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Rate Cut Delivered

Federal Reserve Moves to Bolster Economy

May 15 - For the fifth time this year, the Federal Reserve has slashed interest rates by a half-percentage point to prop up the sagging economy. The central bank today lowered the federal funds rate, - the interest that banks charge each other - to 4 percent. Lower interest rates were needed, economists had said, to buoy consumer spending, the engine that could keep the economy from slipping into recession. A steady loss of jobs threatens to erode consumer confidence. Payroll employment plunged in April, pushing up the unemployment rate to 4.5 percent, its highest level in 2½ years.

Lower rates could also bolster capital spending by businesses. Some observers think the manufacturing sector is already experiencing a recession.

Rate Cut Sparked Debate Among Economists

Just how deeply the Fed would cut rates was a matter of debate among economists. Many predicted that Fed chief Alan Greenspan and his colleagues would see continued downside risks to the economy and slash rates by half a percentage point for the fifth consecutive time, dating to Jan. 3.

It's the fastest series of cuts in the Greenspan era, dating to 1987. Another half-percentage point reduction today would push the federal funds rate to its lowest level in seven years.

Dick Dickson, an analyst with Hillard Lyons in Louisville, Ky., was among those who had been expecting a reduction of half a percentage point. "Given what appears to be still very benign inflation numbers, the Fed is more than likely to err on the side of too much ease rather than too little," he said. "So I think 50 basis points is a done deal."

Others, however, predicted a quarter-point reduction, citing signs of resilience in the economy, including stronger-than-expected growth in gross domestic product, the broadest measure of economic performance.

The Fed maintained its bias toward further weakness, a position that analysts said would foretell additional rate cuts at the board's next meeting, in late June.

"I rather doubt this is the end," said Alan Blinder, a Princeton University economics professor and a former Fed governor. "I think we're getting near the end of the Fed's rate-cutting cycle but I don't think we're at the end yet. I think there will be more to come."

-- (M@rket.trends), May 15, 2001

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05/15 14:32

Fed Cuts Overnight Rate to 4%; Cites Risk of Weakness (Update1)

By John Cranford

Washington, May 15 (Bloomberg) -- Federal Reserve policy makers lowered their benchmark interest rate a half percentage point today in the fifth such reduction this year, and suggested at least one more rate cut is possible.

Fed Chairman Alan Greenspan and his colleagues on the Open Market Committee cut the target rate for overnight loans between banks to 4 percent, the lowest in seven years. As they have with each rate reduction this year, central bankers warned the economy faces a risk of continued weakness.

Commercial banks probably will trim borrowing costs for consumers and businesses immediately, adding a further boost to the economy, which stalled late last year and has recently begun to rebound. Since the first of the year, the Fed has reduced its target rate 2 1/2 percentage points, the most aggressive period of rate-cutting ever by the Greenspan Fed.

Restrained business investment, ``together with the possible effects of earlier reductions in equity wealth on consumption and the risk of slower growth abroad, continues to weigh on the economy,'' the Fed said in a statement accompanying its decision.

Stocks were mixed and the Treasury's 10-year note fell following the announcement.

Another Rate Cut

``Policy makers' focus remains firmly on a slumping manufacturing sector and slowing business investment,'' said Vincent Boberski, senior economist at Dain Rauscher Inc. in Chicago. ``This announcement opens the door to another half-point cut in rates before we can close the books on this interest rate cycle.''

The Dow Jones Industrial Average fell 13 points, or 0.2 percent. The Nasdaq Composite Index rose 14 points, or 0.7 percent. The 10-year note fell 1/8 point, pushing up its yield 2 basis points to 5.44 percent.

The Fed's Board of Governors also voted to cut the discount rate on loans to banks from the Fed system by a half percentage point to 3.5 percent. Although few banks borrow directly from the Fed to meet their cash reserve requirements, the central bank generally keeps the discount rate within a half point of the overnight bank rate.

Unprecedented Effort

Five half-point rate reductions since Jan. 3 constitute an unprecedented effort by Greenspan's Fed to kick-start an economy that grew in the past three quarters at the slowest pace in five years. Never before has Greenspan engineered so large a reduction in the overnight rate in so short a time, including the 1990-91 recession and its aftermath.

In the 14 months from the start of the last recession in July 1990 until August 1991, the Fed lowered the overnight rate 2 3/4 points, to 5.5 percent from 8.25 percent. In the next 14 months, until September 1992, central bankers chopped 2 1/2 more points off the rate, taking it to 3 percent.

Today's cut in the overnight lending rate takes it to the lowest level since it was 3.75 percent in May 1994. Still, it might take six to nine months for the full effect of the Fed's rate reductions to work their way through the economy, economists said.

`Quicker Response'

Greenspan has repeatedly said the Fed had to alter its approach this year as the economy cooled more rapidly than anticipated. ``We have developed, and of necessity will continue to develop, far more quicker response, presumably far more front- loading of response to reflect the changing environment in which we find ourselves,'' he told Congress in February.

While today's Fed statement suggested policy makers aren't ruling out further rate reductions, analysts are beginning to doubt there will be additional cuts unless unemployment surges and consumers curb their spending.

``There's a consensus within the Fed that we'll get some rebound in the second half,'' said David Jones, chief economist at Aubrey Lanston & Co in New York.

Not a Surprise

Today's decision wasn't a surprise. Of 49 economists surveyed by Bloomberg News, 45 expected a half-point cut. The four others forecast a quarter-point reduction. Before the announcement, trading in fed funds futures contracts suggested little chance of any rate cut when policy makers next meet June 26-27 and less than a 50 percent probability of a quarter-point cut by October.

The Fed last lowered rates in a surprise move April 18, when Greenspan conferred with his colleagues by telephone between regular FOMC meetings. That action boosted investor confidence that the Fed will succeed in turning the economy around.

Stocks and the yield on the 10-year Treasury note have risen since then. The Nasdaq Composite Index has climbed almost 9 percent and the Dow is up 6 percent. The 10-year Treasury yield has gained more than a quarter percentage point. Since late March, yields on investment grade corporate bonds also have risen more than a half percentage point.

``The Fed is aware that it had been behind the curve,'' Jones said. That changed with the April rate cut. ``It was a masterful move tactically,'' he said.

Economy Picking Up

There are other signs the economy is about to pick up. Gross domestic product expanded in the first quarter at a 2 percent annual rate, driven by a pickup in consumer spending and construction rose. That growth rate was twice that of the final three months of last year and almost twice as fast as economists had expected.

Moreover, retail sales increased 0.8 percent in April after falling in March and February. And an index of consumer sentiment from the University of Michigan rose this month to its highest level since January.

That could change if the jobless rate keeps rising, as is typically the case even after the economy starts to improve. The economy lost 223,000 jobs in April, more than at any time in the last decade and unemployment rose to 4.5 percent, the highest in 2 1/2 years.

Consumer optimism is ``mostly an employment-related phenomenon,'' Wyss said. That's important because consumer spending accounts for two-thirds of U.S. gross domestic product. If Americans grow more pessimistic, sales may falter again. May's ``employment number is the key,'' Wyss said.

Manufacturing Slump

Manufacturing also remains in a slump, though it accounts for only about 20 percent of GDP. Industrial production fell in April for the seventh straight month, and the amount of industrial capacity in use fell to the lowest point since the end of the last recession.

The decline in manufacturing production may reverse soon. The Commerce Department reported a gain in new factory orders for March, which was mirrored in the latest survey by the National Association for Purchasing Management.

And inventories, which had grown too large, declined in the first quarter for the first time in almost 10 years. ``There's no better excuse for increasing production,'' said Neal Soss, chief economist at Credit Suisse First Boston Inc. in New York.

Auto inventories, in particular, have come back to levels that match demand, Soss said.

One dark spot is business spending on new equipment of the sort that allowed companies to double their productivity gains in the last five years.

``We've had an awful lot of over-investment,'' Jones said. ``It may be a year or two before that completely plays out.''

That's been a concern for Fed policy makers who have repeatedly mentioned the investment decline as a source of the economy's weakness. The concern isn't likely to disappear soon.

Recent surveys show company executives plan to invest less on new equipment this year than last. That will hurt factories. Spending on equipment and software, which grew more than 13 percent a year since 1995, fell in the last two quarters, Commerce Department figures show.

-- (M@rket.trends), May 15, 2001.