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Rate Cut, Market Turmoil Add to Unease Over Economy

January 22, 2008 at 6:10 PM EDT
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Amid fears of a U.S. economic downturn, global markets suffered steep losses and the Federal Reserve slashed a key interest rate by three-quarters of a percentage point Tuesday -- its biggest cut in over 23 years. Financial experts examine why the Fed rolled out the surprise rate cut and the forces behind the market turmoil.

JIM LEHRER: That turmoil in financial markets, Ray Suarez begins our coverage.

RAY SUAREZ: There’s an old adage about U.S. economic turbulence. When America sneezes, the world catches cold. But for the last two days, it looked like the world had caught a bad case of the flu.

Following steep losses on Monday, Japan’s main stock index closed down 5.65 percent today, its biggest percentage drop in nearly a decade.

JAPANESE MARKET ANALYST (through translator): We must consider carefully after observing the upcoming economic figures and market trend. It’s not yet time to be swinging between hope and despair.

RAY SUAREZ: Hong Kong’s index plunged just over 8.5 percent a day after posting its biggest losses since the September 11, 2001, attacks.

FRANCIS LUN, General Manager, Fulbright Securities Limited: People are still apprehensive. And they want to see how the U.S. market reacts to the global financial crisis tonight.

RAY SUAREZ: The Shanghai Composite Index plunged more than 7 percent. And trading in India was temporarily halted after the market there fell nearly 10 percent within minutes of opening. Although it rebounded, it still finished the day 5 percent lower.

In Europe, the fall continued initially, but at the end of the day London’s main index closed nearly 3 percent higher, along with Paris’, up just over 2 percent. Frankfurt’s index was down a 0.3 percent.

In Brussels, the E.U. finance minister blamed U.S. overspending for the worldwide travails and said European markets are in a better position to weather the economic storm.

JOAQUIN ALMUNIA, Commissioner for Economic and Monetary Affairs, European Union: … that we are living in an uncertain period after the starting of the turmoil last August. The tensions in financial markets are still. And during the last couple of weeks, in particular yesterday and today, the equity markets are reflecting these tensions.

Fed makes unusual rate cut

Tom Gallagher
International Strategy and Investment
The Fed doesn't like to create the impression that it responds to the stock market, but given that they cut rates just eight days before the next scheduled meeting, it's clear that that was kind of the exclamation point on their thought process.

RAY SUAREZ: Back in the U.S., just before the markets opened, the Federal Reserve responded with a surprise move of its own. It announced an emergency interest rate cut, 0.75 percent, the largest one-day cut since 1990.

In a statement, the Fed said, "The committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth."

The announcement came a week before the Fed was scheduled to meet anyway. And it came toward the end of a speech from Treasury Secretary Paulson to the U.S. Chamber of Commerce. The secretary said it was the right step.

HENRY PAULSON, U.S. Treasury Secretary: I think it's very constructive. And what I think it shows to this country and the rest of the world is that our central bank is nimble and is able to move quickly and respond to market conditions. And I think that should be a confidence-builder.

RAY SUAREZ: But that confidence did not spread as markets in the U.S. opened. The Dow Jones Industrial Average dropped more than 450 points in the opening minutes of trading.

ALEX YOUNG, Equity Analyst: It's going to take more than rate cuts. Rate cuts are just, you know, positive steps to maybe stimulate the economy down the road.

RAY SUAREZ: On the streets of New York, investors said they're being more cautious.

NEW YORK INVESTOR: It is a crisis, I think. I don't know if it will work, but I hope it does.

NEW YORK INVESTOR: For right now, I'm going a little bit more conservative.

RAY SUAREZ: Those same economic concerns dominated politics in Washington today. On Capitol Hill, Secretary Paulson met with congressional leaders to discuss proposed stimulus plans.

House Minority Leader John Boehner.

REP. JOHN BOEHNER (R-OH), House Minority Leader: I think it's appropriate for Congress to respond. And I think that the only way we can respond quickly is if we sit down and begin to work this out in a bipartisan way. And I'm committed to doing that.

RAY SUAREZ: Later, President Bush met with his cabinet and congressional leaders to work toward an agreement on a stimulus package. The president wants a plan of roughly $150 billion of tax rebates for individuals and families, along with incentives for business investment.

After their meeting, congressional leaders spoke to reporters and said they were hopeful a package would be agreed on within weeks.

Speaker of the House Nancy Pelosi.

REP. NANCY PELOSI (D-CA), Speaker of the House: We would not want to contribute to any feelings that a recession is imminent, but we do know that there has been a downturn. And we want to lessen the impact of that and prevent it from getting to be more of a downturn.

So this is about one thing in this package. Is it a stimulus? So whatever it is that we are considering, it must meet that one criterion. Does it stimulate the economy? Does it put money into the hands of those who will spend it and to do so to inject demand into the economy to create jobs to turn the economy around?

RAY SUAREZ: A short time after the meeting, President Bush said he still has faith in the American economy.

GEORGE W. BUSH, President of the United States: This administration is monitoring our economy very carefully. Secretary Paulson is frequently giving me updates about conversations he's had with people around the world and, obviously, people inside America about our economy.

We have confidence in the long-term strength of America, and so should the American people. This is a flexible, this is a resilient, this is a dynamic economy. And the entrepreneurial spirit is high.

RAY SUAREZ: In fact, by the end of the day, Wall Street rebounded some. The Dow Jones was down 128 points, a decline of 1 percent for the day.

For some analysis now of what's behind the turmoil in the markets and today's response by the Federal Reserve, we turn to Tom Gallagher, senior managing director at the investment firm International Strategy and Investment.

David Jones, president of DMJ Advisors, a financial and economic consultancy.

And David Malpass, chief economist at Bear Stearns.

Rates cut early to head off markets

David Jones
DMJ Advisors
I think the Fed was, up until today at least, quite far behind the curve. They had not recognized the severity of this credit crisis.

RAY SUAREZ: Tom Gallagher, the Fed didn't even wait, felt it couldn't wait until its regularly scheduled meeting and, when it cut, cut big. Why?

TOM GALLAGHER, International Strategy and Investment: I think there are probably at least three reasons that led to this.

The first is the worry that the losses at banks, that banks were realizing because of subprime losses and related losses, were going to cause them to restrict their lending, which is going to have a negative effect on the overall economy.

The second is data came in on the economy to support the idea that the economy is slowing because of these tighter credit conditions. You had the employment report for December, which showed an increase in the unemployment rate of 0.3 percent. Retail sales were weak. So you had a number of indicators that suggested this was a real-time issue.

But the third thing is the stock market meltdown on Monday. The Fed doesn't like to create the impression that it responds to the stock market, but given that they cut rates just eight days before the next scheduled meeting, it's clear that that was kind of the exclamation point on their thought process.

And I think the Fed thought that they had to act to avoid this kind of downward spiral, where you get decline in investor confidence reinforcing declines of business confidence and then household confidence, as well. So I think they felt that they had to act to prevent that.

RAY SUAREZ: David Malpass, do you agree with that analysis, first off? And do you see this as a significant event?

DAVID MALPASS, Chief Economist, Bear Stearns: I agree with what Tom said. And, yes, it's a significant event in that the Fed is moving aggressively.

I think the Fed's come in unduly for criticism. Some are saying it's behind the curve. But in my reading of it, the Fed is well ahead of where it was in previous slowdown cycles.

It's already got the interest rates down to 3.5 percent. Remember, in 1990, the absolute bottom of the interest rate cycle was 3 percent, and that was well after the recession was over.

So it seems to me the Fed is acting quite proactively and has gotten interest rate levels down to a very stimulative spot right now.

RAY SUAREZ: David Jones, do you agree, the Fed ahead of the curve? A lot of people have been criticizing it for being slow to respond to the credit crunch, for instance.

DAVID JONES, Wall Street Analyst: No, I think the Fed was, up until today at least, quite far behind the curve. They had not recognized the severity of this credit crisis.

First, they thought it would be confined to the subprime area of the mortgage market. It has since spread from the mortgage market to credit cards and auto loans. It has hurt the economy much more than the Fed I think originally thought.

So I think today's action, being extremely urgent on the part of the Fed, was an effort to catch up with the curve, to recognize how severe this credit crisis is, how severe the increase in the cost of credit is to households and businesses, and the danger that that might push the economy into recession.

The Fed never uses the word "recession," but, indeed, we could already be in one.

Economic shock wave hits everyone

David Malpass
Bear Stearns
I think it really comes down to the size of the U.S. in the world economy. We tend to forget or think of ourselves as weaker than we really are. The U.S. GDP is $14 trillion. It's a giant chunk of the world and a big provider of world growth.

RAY SUAREZ: David Jones, over the last several days, and not only in U.S. exchanges but in exchanges all over the world, we've seen the book value of companies decline by billions upon billions of dollars. Is that a product merely of market psychology or, in fact, are those companies worth less, if people feel that American consumers are going to stop spending money?

DAVID JONES: Well, it's clear that one of the major crises here was that banks not only were reluctant to lend to households and businesses, but they were reluctant to lend to each other, because they were worried about the credit worthiness of other financial institutions. That's an extreme condition to have.

And I think the Fed had been trying to supply emergency liquidity on one track to deal with that, but they simply had to move more aggressively to cut rates.

This is a serious crisis. It's not just in the U.S., but indeed it has been showing up in the U.K. and in the euro zone. Growth over there is beginning to slow.

And this whole theory about whether or not the rest of the world was decoupled from the U.S. is being shot down, has been shot down, really, today, as we've seen equity markets around the world declining sharply.

So, all in all, it was clearly a credit crisis that was greater than the Fed thought. The effect on the economy in slowing growth was greater than the Fed thought. And they had to act urgently.

RAY SUAREZ: David Malpass, why is the financial sector in the rest of the world so heavily tied to the United States, even now, with fast-growing economies in places where there weren't before, with new middle classes and so many countries in the world? Why is American consumer still so important?

DAVID MALPASS: I think it really comes down to the size of the U.S. in the world economy. We tend to forget or think of ourselves as weaker than we really are. The U.S. GDP is $14 trillion. It's a giant chunk of the world and a big provider of world growth.

And so as we go through problems -- and there was, I think, a serious negative change in August, with the breakdown of the securitization process -- that tends to, with a lag, shock the rest of the world.

So I think there was -- a lot of what was happening yesterday and today in world financial markets was a realization or a sinking in that they were not separate from the U.S. It's a globalized economy, and we all depend to some extent on each other, in terms of both capital and final demand.

RAY SUAREZ: But do these places, Tom Gallagher, also have problems of their own, apart from what's happening in the United States?

TOM GALLAGHER: Well, to some extent they do, but I think David Malpass is right, that the primary effect of this is that the U.S. is an important market for the rest of the world. And the rest of the world could probably have absorbed a mild slowdown in the U.S., but I think, as the news accumulated that the U.S. is going through a more significant slowdown, the rest of the world couldn't really absorb that.

The other point, though, is that the spending might have been here in the U.S., but the debt -- that is, the packages of securities of subprime mortgages and other debt -- were sold to foreign investors, so there are foreign losses. There are losses in these foreign economies.

I think European banks in particular own a lot of the U.S. debt, so that's another important effect that the international markets are absorbing.

Fed aims to calm recession fears

RAY SUAREZ: We saw the secretary of the treasury out today reassuring not only Americans, but the rest of the world that, in his words, the central bank is nimble and can move quickly in response to market conditions. Is that enough reassurance? Or, I guess, are we going to see?

TOM GALLAGHER: Well, to me, the extraordinary thing is that, over the last two weeks or so, there's been a lot of positive news on how much stimulus is going to come from Washington.

The Federal Reserve chairman, Bernanke, gave a speech on January 10th that signaled a more aggressive approach. There's been a lot of positive news about fiscal stimulus. Yet despite that, markets have deteriorated.

And I think it's not because they see this as ineffective. I think it's all welcome stimulus. But the market has been downgrading the underlying path of the economy even more as the credit problems have built up and as the economy has deteriorated.

So I think it's important that Washington is doing what it's doing, but I just think the markets are more worried about the economy than they were at the start of the year.

RAY SUAREZ: So does that mean, David Jones, that the rest of the world is even more pessimistic about the near-term future of the United States economy than we realize?

DAVID JONES: I certainly think so. What we can look at is the emergency action by the Federal Reserve.

Certainly, the urgency they showed in today's action, along with fiscal stimulus, prompting tax relief, as well as increases in some spending areas, being just enough to keep the recession or the very pronounced period of slow growth from dropping even further, it's sort of giving downside support to an economy that's already weak.

But given an already weak U.S. economy, inevitably that spreads to Europe and probably even to Asia, despite their strong growth, since Asia still depends very much on exports to lead that growth.

So we're all in the same boat. And I think the view would be here that, while the U.S. is doing some good on the stimulus side, it's come quite late in the process.

RAY SUAREZ: David Malpass, let's talk a little bit about what happened in the United States today.

When the markets were closed yesterday for the King holiday, the futures were plummeting. Then, when the market opened for business this morning, 465 points right off the opening bell. And then the market clawed back most of that. What does that mean?

DAVID MALPASS: I think it took a little while for the realization to settle in of what the Fed had done, so I don't read it quite as negatively. I think the initial reaction when the Fed came out this morning was a positive one. There was some residual, you know, down news for the opening, but then all day long it was climbing.

I think the Fed is dealing with a very hard position. The amount of excess liquidity in 2004 and 2005 was massive, so it built up kind of bubbles and distortions around the world in the economies. And now we're dealing with the hangover.

So I'm actually pretty optimistic about the longer term. We're dealing with, and have been since August, a very serious short-term financial market situation. The Fed's been dealing with it aggressively. A lot of problems have been fixed.

The SIV problem that was in the news earlier, the LIBOR problem, a lot of the short-term problems have been resolved. And now we're looking at the longer term growth impact of the current situation.

And I think it's pretty good. The unemployment rate is 5 percent. The Fed has the interest rate at 3.5 percent. These are very stimulative levels in normal parlance.

RAY SUAREZ: In the very little bit of time we have, the Open Market Committee is going to meet as scheduled next week. David Malpass, do you expect yet another rate cut? Very quickly.

DAVID MALPASS: I'm not sure. I think they've got to form a committee view. And it will matter a little what the data in the financial markets do between now and then. I'm interested in Tom's view of that. He watches it very closely.

RAY SUAREZ: Well, let me stop by with David Jones first.

David, another rate cut in the offing, do you think?

DAVID JONES: I think it's still up in the air, even on the Fed's part. I do think by, let's say, March, looking beyond the January scheduled meeting, we will be down from the current level of 3.5 percent to 3 percent in that overnight funds target.

But I think the timing of the next 50 basis points in rate cuts is very much up in the air. It might be too soon to cut in January. The Fed does not want to be perceived as just responding to the equity markets. They'll never be able to give the equity markets all they want.

RAY SUAREZ: And very quickly, rate cut?

TOM GALLAGHER: I think they'll probably cut by 0.5 percent a week from tomorrow.

RAY SUAREZ: Gentlemen, thank you all.