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Another Rate Cut

August 21, 2001 at 12:00 AM EDT
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RAY SUAREZ: The most aggressive easing of interest rates in two decades continued today. Alan Greenspan’s Fed cut the benchmark federal funds rate by a quarter-point to 3.5%. Here to analyze the move and the economy that prompted it are: Susan Phillips, dean of the George Washington University School of Business and public management– she was a member of the fed’s board of governors from 1991 to 1998; and Ron Blackwell, an economist and director of corporate affairs at the AFL-CIO. Well, Susan Phillips, along with the announcement, the board offers a rationale and a forecast. What did the fed have to say today?

SUSAN PHILLIPS: Well, i think that they were certainly paying attention to the fact that corporate profits have been down and business expenditures have been down. So they wanted to continue to create more of an environment that would be conducive to investment.

RAY SUAREZ: How does a quarter point interest rate cut do that?

SUSAN PHILLIPS: Well, it certainly lowers generally the cost of capital, but you’re quite right in the sense that it may not mean that corporations necessarily spend more that quickly. They’re going to have to work off some inventory, and there’s still significant excess capacity. But I think that they were trying to continue support for consumers to spend, to buy houses and to keep the labor market strong.

RAY SUAREZ: Ron Blackwell, should this be red as a sign that the Federal Reserve board of governors is not optimistic in the near term?

RON BLACKWELL: Well, I think it’s actually more important, as a sign of where the Fed is at in terms of its outlook for the economy. And i think it was encouraging that they continue to see that the downside is on the softening of the economy, the deceleration because that’s where the problem is, and that’s where the danger is. So in this way, we were very encouraged by this move, although we… The question remains of whether this is going to be sufficient to turn the corner in the real economy, whether it’s capable of changing… Turning business investment around and restarting the real economy.

RAY SUAREZ: Whenever there’s a rate cut– and there’s been a awful lot of them lately– we’re often told that the effects of it won’t be felt for some time. Since this round of easing rates started seven months ago, are we seeing the effects of those early cuts now? Is there any sign that this is working as a tool?

RON BLACKWELL: Well, I think it’s very hard to see it that easily and that readily in its connection to the real economy. And the real question is: The projections of the real economy are always going that the recovery will come in the second quarter and then it was the third quarter and then it was the fourth quarter and now it’s 2002. But the real challenges here is the motor of the recovery is still not over the horizon. Where is the demand going to come to turn this economy around? The consumer is what has held the economy from… keeping us from out of a recession, but the consumer is in no position to motor a brand new economic cycle here. Business inventories, even when they’re worked off, aren’t likely to stimulate a turnaround in investment quickly. The international economy is nearly as flat on its back as we are. And our net… Our external balance, the difference between our imports and exports, is nearly 5% of GDP. And therefore, it’s a major weight around the economy’s neck. So where the demand come to get the real economy going, which is the question that i think occurred on Wall Street this afternoon and why there was a major sell-off.

RAY SUAREZ: Do you agree with that analysis?

SUSAN PHILLIPS: Well, you know, i think that probably the rate cuts don’t affect all parts of the economy equally and at the same time. And a rate cut does affect the housing market more quickly. But we’ve actually had housing being held up quite well during this entire period of time, so we don’t have housing really to sort of lead us out. And the consumer has been spending. Consumption has held up quite well during this slowdown. So i agree. I think there’s a question as to where the driver is going to be, but i think from the Fed’s perspective to the extent they can continue to support consumption till the tax rebates start to kick in and people start spending those, that may be– provide a bit more of a kick to the economy.

RAY SUAREZ: As a tool, is an interest rate rise or reduction more effective when you’ve got a hot economy that you’re trying to cool, or do we have evidence that it works when you’ve got sort of a sluggish one that you’re trying to kick up into a higher meter?

SUSAN PHILLIPS: Well, I think you’re quite right. I mean to the extent monetary policy isn’t going to be a panacea for everything, and at best monetary policy can provide an environment that’s conducive to economic growth and consumption, but it’s got to be businesses that in fact are hiring people and putting people to work. And that is the engine that really is going to be the most successful in driving the economy. So monetary policy is a part of the whole picture, but i don’t think it can do everything. So it’s a help, but it’s not everything.

RON BLACKWELL: You’re making an important point, Ray, because a little bit of monetary pole is like pushing a string. It actually is more effective when you’re raising rates to slow down an economy to keep inflation under control. But when turn around and you have a sonic economy and try to push the string, it doesn’t work as well. And our counter cyclical policy has become so unbalanced as between fiscal and monetary policy, that we’re trying to turn around an economy that’s slowing down because of this rapid deceleration of investment spending, and we’re countering that only with monetary policy. And we’re very… We’re tipping on the edge of a recession. It’s a very tricky time right now.

RAY SUAREZ: Is conventional wisdom taking a little bit of a knock during this year, with rates coming down so rapidly, some of the things that we’re told are supposed to happen in that atmosphere aren’t happening. The dollar hasn’t gone down in international trading in line with the interest rate cuts. Inflation isn’t really part of the picture. The last Consumer Price Index numbers were negative. So what are we supposed to understand about the connection between interest rates and other things that are happening in the economy?

SUSAN PHILLIPS: Well, i think that there are some… There are some connections. But you know, clearly, you know, people have to have a reason to spend; businesses have to have a reason to invest. And so when they start to feel confident enough that there’s going to be sustained demand and when we work through this inventory, then i think we’ll start to see increased investment. We have seen the dollar come down somewhat, but i think that, you know, the whole point about the global slowdown is also putting a bit of a constraint on the effects the Fed might have.

RAY SUAREZ: Some of those other effects that are supposed to go along with it are a rising stock market and bond prices being affected by this. And those two indicators haven’t changed that much either.

SUSAN PHILLIPS: Well, you know, it’s hard to know where with the stock market. I mean anybody who tries to predict the stock market’s probably going to have a tough road to hoe. But I would say that i think we may look back on this period of the stock market and see this as a very orderly correction. And i think most people would say that stocks have gotten pretty pricey, P.E. ratios were pretty much out of sight. So some realignment of earnings and valuation i think is in order. So… And i think, you know, the fact that it’s sort of moved sideways, at least the major… Say the Dow-type stocks, S & P 500, i think is a healthy thing in the long run. And some of the technology companies had really gotten way overpriced, I think. So some correction i believe was in order.

RAY SUAREZ: Is there an end in sight to this, Ron? Is there a point at which this ends up not really making much difference to the fundamentals, these reductions in the Federal Funds rate?

RON BLACKWELL: Well, as Susan said, it’s very difficult to predict the future. But i do think there are some positive signs. I mean the stock market hasn’t collapsed. But the prices have come down. But the price earnings ratios are still pretty high.

SUSAN PHILLIPS: Yes.

RON BLACKWELL: There’s still air under these markets, and they could come down further. But a most promising sign to me that the fact that we were assuming not so long ago that we had a new economy, and the difference between the financial world and the real world was not important. And now at least we see that the real economy and the failure of earnings in the real economy and the slowdown in the real economy is getting the attention of people on Wall Street.

RAY SUAREZ: You seem relieved that the real economy is still real.

RON BLACKWELL: Well, i think… No. I know that it’s real. We represent people who live and work in the real economy every day, and that’s true of farmers, as well, and industrialists, and they’re all expressing concerns about the current state of the real economy. And i personally don’t think we’re going to get out of this problem in the real economy until the dollar does come down because I think, if it is completely overvalued, it’s being driven counter intuitively by capital flows and not the trade imbalance that we have. And it’s keeping U.S. exports overpriced and it’s under pricing imports from abroad. And until we get that straightened out, we’re not likely to see a sustained recovery because even with the rebates that we recently discussed, there’s a question about whether that gets spent or whether people save that money. And then even if they do spend it, do they spend it on goods that power the U.S. economy, or do they spend it on imports, in which case it’s nothing for the real economy.

SUSAN PHILLIPS: The other thing i would add is the rest… Hopefully the rest of the world is going to start to strengthen so that they can buy U.S. products. So one of the problems with this imbalance is that other countries haven’t been able to buy U.S. goods. So we need to see the rest of the world strengthen so we can sort of get into a situation where all boats are rising again.

RAY SUAREZ: Susan Phillips, Ron Blackwell, thank you both.

RON BLACKWELL: Thank you, Ray.

SUSAN PHILLIPS: Thank you.