U.S.: The Fed's Magic Tonic Isn't Working (NY Post)

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Headline: The Fed's Magic Tonic Isn't Working

Source: John Crudele, New York Post, 26 June 2001

URL: http://www.nypostonline.com/business/33372.htm

The Federal Reserve is meeting this week, and by tomorrow we should have our sixth interest rate decrease of the year.

Six! In just six months.

And whether you are a corporate executive wondering where all your business has gone, an investor trying to figure out why the value of your portfolio disappeared, or a consumer puzzling over what's going on with the family budget, here's a bit of advice.

You can start worrying now.

I don't want to be accused - again - of being a gloom-and-doomer. Like everyone else I hope the economy suddenly picks up, and we are all floating in dough again by the time the kids get back to school.

But I'm also not going to get drafted into the Pollyanna conspiracy.

Times are hard. The nation's economy is in a bad state that is made worse by the fact that the good times ended so abruptly with last year's market shock.

And we are all going to be a lot worse off if we deceive ourselves into undeserved optimism. You can't solve a problem until you identify it.

So here is the problem that the Fed faces this week.

Over the last decade the U.S. economy has become excessively reliant on the stock market. People made money playing in the market, and they'd regularly cash in some of those winnings and buy things.

Cars, boats, houses - the sales of all luxury items soared. And the things we needed every day were also gobbled up.

But the stock market also bought people confidence. With the market rising, people felt that their retirement plans and the kids education and money for the daughter's wedding were all taken care of. So they could spend their salary on other things. Savings were being taken care of by Wall Street. Manufacturers borrowed lots of money, built new facilities and revved up their production of everything.

Under these circumstances, inflation should have climbed rapidly. But two important things happened. First, the government repeatedly changed the way it calculated price increases. The rise in housing prices, for instance, was tracked in a way in which soaring real estate values all but disappeared from the inflation gauges.

But inflation was also handled because demand for goods - thanks to the so-called "wealth effect" from Wall Street - kept rising fast enough to keep manufacturers building.

America was a happy place. So happy, in fact, that we started to invest in companies that really weren't companies. With the Internet, America had its version of the great tulip craze.

Then it all ended - quite suddenly. Very unexpectedly.

Six months ago the Federal Reserve started using conventional medicine to fix the problem. So far this year, the rates on the overnight funds that the Fed controls have come down 250 basis points - or 2.5 percent in layman's language. We should get another quarter-point or half-point interest-rate cut tomorrow.

But no matter how cheap borrowing money becomes, companies aren't going to take out loans to build facilities they don't need. And while consumer confidence still remains relatively high, rational people aren't going to make unnecessary purchases at a time when they fear layoffs.

And companies will continue to let workers go if their profits remain depressed.

You see the vicious cycle. Lower company profits lead to layoffs, which lead to lower consumer spending, which lead to lower corporate profits and layoffs, which lead to less spending.

Could the Fed's rate cuts still have an effect? Sure. But tomorrow's action, or the one after that, or the one after that could just as easily stoke very real fears of inflation. I hope that doesn't happen. But anyone investing in this market needs to know these risks.

-- Andre Weltman (aweltman@state.pa.us), June 26, 2001


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