Fed to swat at deflation with rate cut
Published by Florida Times-Union on June 25, 2003.
Own a house? Your mailbox is probably full with offers from banks who want you to refinance.
If you have student loans, the mailman's bag is even fuller from all those refinancing offers. And even if you're a debt-free renter, you can't turn on the radio without a car dealer screaming at you about low (or 0 percent) interest rates.
It's probably not going to change any time soon.
The Federal Reserve's short-term interest rate is already at early-1960s levels. This afternoon, following the central bank's second day of meetings, the Fed is expected to slash it again, to a point not seen since Dwight Eisenhower was sitting in the Oval Office.
Spooked by the possibility of the American economy entering the type of deflationary spiral that Japan is falling through, the Fed has been sending signals for more than a month that the short-term interest rate -- what banks charge each other for short-term loans -- may be dropped from its current 1.25 percent. The only questions in many economists' minds is whether the drop will be a quarter-percent cut or a half point -- and whether such a cut is even necessary.
The short-term rate is used as a benchmark for other interest rates, so when the Federal Reserve makes changes, it causes a ripple effect throughout the economy, causing everything from mortgage companies to credit card providers to charge less.
On May 6, the board issued a statement saying that "the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level."
� -- Rick Wilson/staff
------------------------------------------------------------------------In other words, inflation might be dead. Deflation -- when unemployment jumps while productivity and prices drop -- might be creeping up on us.
Such remarks by Federal Reserve Chairman Alan Greenspan and other officials have prepped the business community for a possible rate cut.
"The Fed learned somewhere along the lines, probably in the '90s, that it was a mistake to surprise the markets," said Allan Meltzer, a visiting scholar at the American Enterprise Institute. "A central bank that tries to keep things secret surprises the market. Rather than using markets, that shakes them up. Now they try to avoid giving shocks to markets."
The board's indications have already had an effect, leading investors to snap up bonds, pushing up their prices and leading long-term interest rates to drop. Now, several economists said, a rate cut would almost be designed as a comforting move for investors, a way of reassuring them that the central bank thinks the economy is poised for growth.
"It shows how aggressive this board is in combating a slowdown in the economy," said Roger Tutterow, director of the Econometric Center at Kennesaw State University in Georgia and chairman of its Department of Economics and Finance. "It signals to markets and to consumers that they'll keep trying to stimulate growth."
There is, however, a downside to an interest rate cut, primarily the effect it could have on money market accounts. This could be particularly bad for retirees, said David Lenze, an economist on staff at the Bureau of Economic and Business Research at the University of Florida, as the interest thrown off by their retirement account dwindles.
If rates drop low enough, investors would likely move their savings from money market mutual funds to bank accounts, where they'd get the same return, but have the benefit of a federal guarantee.
Of course, not everyone believes a rate cut is necessary -- or will have much of an effect on the economy. Rental vacancies are at one of the highest points in decades, implying that people looking to buy houses have already jumped into the mortgage markets, zero interest car loans have already lured many to purchase new cars, and student loan refinancing companies have been trumpeting "rock-bottom rates" for the past year.
"The announcement may actually have the opposite effect of what's intended," said Paul Mason, chairman of the Department of Economics and Geography at the University of North Florida. "It could send a signal to consumers whose confidence is starting to return that they might have reason to worry. If it were up to me, I wouldn't cut rates."
The dozen rate cuts made since January 2001 -- which have dropped the short-term rate to its lowest level since July 1961 -- might have been enough, experts said. (A quarter-point cut or more would drop the rate to its lowest point since 1958.) Many consumers refinanced mortgages and student loans after the last cut, Mason said, leaving "not much demand" in the market.
"I think people are already responding to the low interest rate," agreed Meltzer, who is also a professor of political economy and public policy at Carnegie Mellon University and author of The History of the Federal Reserve. "It will end up that they're doing this as a sort of insurance policy."
Dropping from the already-low rate won't necessarily spur businesses to borrow, said Keith Perry, executive vice president of CenterBank of Jacksonville, because companies, especially smaller ones, only go to the bank when they need to.
"Personally, I'm in the ring with the people who think that lowering rates further won't particularly be stimulative," Perry said. "It's more an act of moral suasion on the Fed's behalf to try to convince the market about it being serious about attacking deflation."
But that signal might be all the economy needs.
"The Fed realizes that all it can do is provide an environment conducive to spending," said Tutterow, the Econometric Center director and consultant. "In the end, businesses make decisions about investing in capital projects based on their needs and how profitable they think the project is going to be."
That's one reason several observers believe a quarter-percent cut is more likely than one of half a percent. "What the markets would really like to see is a confirmation from the Fed that the economy is starting to expand," Tutterow said. "The only real worry is if the public starts seeing this as a sign of desperation on the side of the Fed."