TCS Daily


Interest Rates Have Almost Hit Bottom, and So Has the Economy

By Kevin Hassett - May 29, 2001 12:00 AM

The economic data have continued to be pretty lousy over the past couple of weeks. As anticipated in an earlier column ("The Good News on GDP May Be No News At All," May 3rd), inventory investment dropped further in March. Just as before, the picture painted by the release was not very promising. While investment dropped, businesses saw their sales drop even more, and the ratio of inventories to sales held steady at a high level. It looks like April will not be a strong inventory month either.

Everything else stunk last week. Initial claims for unemployment insurance, a key up-to-the-minute indicator of the health of labor markets, jumped in May. Orders for durable goods dropped sharply in April. Even the housing data have finally turned sour. At last, all the data releases seem to be singing the same tune.

A pessimist will look at these developments and head for a bomb shelter. The end is near! My own feeling is, however, that the signs that we have hit bottom are beginning to be rather convincing. If an end is near, it is not the end of economic life as we know it, but rather, an end to the long run of bad news. That's one reason the stock market has been celebrating as of late.

Why are we likely to begin to turn around now? The biggest factor is that the Federal Reserve, after dropping rates another 50 basis points, is no longer a factor pushing the economy in the wrong direction.

How's that? Didn't the Fed start helping us out last January? Well, sort of.

If you are a connoisseur of Federal Reserve statements, you will know that the Fed has often said that the economy responds rather slowly to interest rate policy. This is a well-accepted view, one backed by oodles of empirical work. Why does the economy respond slowly to Fed action? My own feeling is that the tension between current rate reductions and consumers' and firms' expectations concerning future reductions explains the pattern.

Here's why. When the Fed started cutting rates in January, it was obvious that the economy was hurting and that further reductions would be necessary. If you were contemplating the purchase of a new car back then, it was hard to get motivated to pull the trigger. Since the Fed was likely to lower interest rates even more at subsequent meetings, you would be locking in a loan at a high rate. The gain to waiting a few months was enormous. Since then, short-term rates have dropped from 6-1/2 percent to 4 percent. That kind of reduction can save you thousands of dollars over the life of a car loan.

What followed was predictable. Firms and consumers stopped buying things, and waited for interest rates to stabilize at a lower level. Now, that waiting can-and likely will--stop. Futures markets expect the Fed to lower rates by another 25 basis points by the next meeting, and then to stop cutting rates. The gain to postponing purchases is now close to zero.

If this episode is typical, we can expect businesses to open up their checkbooks and start buying right now. The odds continue to be that we will dodge a recession.

It is clear, however, that the step-by-step Fed action helped bring us close to the abyss. Just as the economy was softening, the promise of future rate reductions made it soften even more. Which brings up the question, why didn't the Fed just cut rates 250 basis points last January?

If you asked them, here is what they would say. The Fed needs to move systematically and conservatively because the fear of abrupt Fed actions would increase the volatility of financial markets. Since markets think that 50 basis points is the largest possible move, they don't have to factor in the possibility of massive swings in interest rate policies, swings that would generate enormous short run losses and gains. Imagine the tension financial markets would be exposed to if everyone were sitting around waiting for a 250 basis point cut!

That argument may be right, but the cost is that Fed stimulative policy is weaker when a succession of moves is expected. If we dodge a recession nonetheless, then that cost may not be too much to bear.
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