PAUL SOLMAN: Today's decision to drop interest rates is the Fed's second in two months. It suggests a consensus at the Fed that the economy is slowing. To help explain what the Fed did and what it means we're joined by Greg Mankiw, Professor of Economics at Harvard University. And Greg, thank you. Thank you for joining us.
GREGORY MANKIW, Harvard University: Nice to be here.
PAUL SOLMAN: First, what did the Fed do, and is it a big deal?
PROF. MANKIW: Well, it's a small deal. What they did is they cut two interest rates by a little bit, only 1/4 of 1 percent, the discount rate, which is the rate they lend money to banks at, and the Federal Fund's rate, which is the rate at which banks lend to each other, and that interest rate will slowly move its way through the economy by forcing all other interest rates down, interest rate that banks lend to households and that banks lend to firms, and that'll change behavior of households and firms.
PAUL SOLMAN: Could you explain that a little more slowly perhaps. What's the cause and effect here? I mean, what's the mechanics of the Fed drops these interest rates, what happens, and what's the Fed hoping will improve the economy as a result?
PROF. MANKIW: Well, the first thing is the banks see that the cost of funds to them has fallen by 1/4 of a percent, and then they start cutting interest rates that they charge their customers, and we've already seen that starting to happen today. After a while, people see that those lower interest rates make borrowing more attractive, mortgage rates will fall, people will buy more housing and bigger houses, and more people will decide to go buy that first home, more firms will borrow to invest in plant and equipment, and that's going to stimulate demand for goods, and that stimulation of the demand for goods will stimulate employment in those industries.
PAUL SOLMAN: So is it fair to say that it's mainly because money is now cheaper than it was--
PROF. MANKIW: Absolutely.
PAUL SOLMAN: --yesterday?
PROF. MANKIW: Absolutely.
PAUL SOLMAN: All right. Now broadly speaking, why did the Fed decide unanimously to lower interest rates this time around?
PROF. MANKIW: Well, the Fed is really looking at two things. On the one hand they're looking at the inflation picture, and inflation looks quite benign, so they're not very worried about that, that problem.
PAUL SOLMAN: But we heard in the News Summary that inflation, in fact, the Producer Price Index went up the second straight month by quite a lot, 1/2 percent.
PROF. MANKIW: Yeah. But the Producer Price Index is a very volatile series. If you'll look at more of the series in other forms of, other indices, the Consumer Price Index, wages, inflation looks pretty benign, despite the 1/2 percent blip in the Producer Price Index. So inflation basically looks pretty good. The other thing the Fed is looking at besides the benign inflation picture is the growth in the economy, and there are a variety of signs that the economy is starting to slow and that's what really motivated the decline in interest rates.
PAUL SOLMAN: So what are some of the signs or signs that economists in general agree are reliable indicators that the economy is actually slowing down?
PROF. MANKIW: Well, there are literally hundreds of different indicators, and Alan Greenspan is a great consumer of economic data, so he looks at them all.
PAUL SOLMAN: Let's not look at them all. Why don't you just pick out a few for us.
PROF. MANKIW: I think the two that he's probably looking at the most are first the declining retail sales, or really slowing of growth of retail sales, which came out earlier this week. It looks like Christmas was not quite as good a Christmas as retailers, as it had hoped. And second, it looks like consumer confidence is falling. There are a variety of surveys of households asking consumers how confident they feel, and they don't feel that confident. And I think that's making people nervous, the growth in the economy in the year ahead.
PAUL SOLMAN: But now forecasters are predicting growth in the economy. I mean, the consensus forecast I heard the other day is for some growth. So then why would you need to stimulate the economy if there's going to be growth anyway?
PROF. MANKIW: Well, there's some normal rate of growth, say roughly 3 percent, that the economy needs to maintain unemployment at its current level. If, if growth falls below that level, unemployment is going to start to rise, and that's what they want to avoid.
PAUL SOLMAN: All right. So now, who's going to be happy that the Fed lowered rates and who's going to be unhappy?
PROF. MANKIW: Well, I think people--
PAUL SOLMAN: Not names now, just classes of people.
PROF. MANKIW: I think any borrower is going to be happy, and any person who's living off the interest income is going to be unhappy because that money market fund is going to be earning a smaller rate of return.
PAUL SOLMAN: So a borrower is going to be unhappy because--
PROF. MANKIW: The borrower will be happy--
PAUL SOLMAN: Happy.
PROF. MANKIW: --happy because borrowing will be cheaper. The interest rate they'll pay will be a little lower.
PAUL SOLMAN: Does that mean that we're going to--people are going to consume a lot more and we're going to have this overspending that the American economy is sometimes accused of doing if people, you know, their credit card costs are lower and so forth?
PROF. MANKIW: That is one possible effect. Interest rates are thought to primary affect investment spending, particularly spending on residential housing, so I think this is particularly good for home builders, who are going to tend to see residential housing a little stronger than they might otherwise.
PAUL SOLMAN: Now, what is the move today for the Fed mean for the majority of our viewers, if there's any way to sort of characterize them? I know you don't know them all, but the--is there a way to generalize about this, yes, borrowers are happy and the lenders are not happy, but--
PROF. MANKIW: I think it primarily reduces the cost of borrowing, which is going to tend to stimulate the economy overall. I think it means that the Fed is being very vigilant to avoid recession, and anybody who's at risk to be unemployed should be happier, happy in that regard.
PAUL SOLMAN: Here's a tricky question maybe. When will we know if this was the right decision, if in fact, the economy was slowing down enough so that we needed, this Fed needed to stimulate it at this point?
PROF. MANKIW: Probably not for six months to a year. Monetary policy works with a very long lag, as I said six months to a year, and that makes evaluating and making monetary policy very tricky, so the Fed is really trying to decide today what is the economy going to look like a year from now in deciding whether to cut rates. If a year from now it looks very strong and inflation has taken off a little bit, today it will have been the wrong thing to do.
PAUL SOLMAN: But will we really know I mean even then? I mean, will economic historians be able to say absolutely the Fed did the right thing because now, six months, a year from now, we know that they--they they did?
PROF. MANKIW: I think we'll have a much better sense than we do today. The thing the Fed lacks most is a crystal ball. And with the benefit of hindsight, we'll know whether today we needed stimulation or not.
PAUL SOLMAN: You know, one thing you hear a lot about is that the statistics aren't very good, government statistics. They haven't been coming out for a while and so forth. I was wondering if whether--if economists are questioning whether or not the Fed has an accurate basis on which to be making the predictions it's making, and whether the Fed should be adjusting, making these tiny adjustments, such as it is anyway? I mean, is there a consensus in the economics community about that?
PROF. MANKIW: Well, I think there's not a consensus on whether the Fed should fine tune. I think--
PAUL SOLMAN: And this is fine tuning if it goes down 1/4 of a percent--
PROF. MANKIW: Sure, absolutely, there's no question the Fed has done a lot of fine tuning here. They're doing a very good job of it. They have, but I think there's no question that it's very hard to do, given that we really need a crystal ball that we don't have.
PAUL SOLMAN: Doing a fine job of it because--
PROF. MANKIW: Because what we have is a situation where growth has been fairly steady, inflation has been low, and we've basically avoided major economic fluctuations during the Greenspan era. I think most economists think Greenspan has done quite a good job.
PAUL SOLMAN: And the guess is that he's continuing to do that?
PROF. MANKIW: I mean, so far, so good.
PAUL SOLMAN: All right. Well, thank you very much, Greg Mankiw of Harvard.
PROF. MANKIW: Thank you.