Interest Rates Down, DOW Up
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PAUL SOLMAN: Well, today, to the surprise of many observers, given the budget impasse, the Federal Reserve Bank cut interest rates by one quarter of 1 percent, the stock market down 101 yesterday, up 34 today. So to talk about the Fed cut, the budget impasse, and the stock market, we’re joined by Karl Case, professor of economics at Wellesley College, and in Washington, Tom Gallagher, the senior vice president for the investment house Lehman Brothers. Gentlemen, thank you both for coming in. Prof. Case, we’ve been hearing the Fed would not cut unless, in fact, there was a budget deal. So what happened?
KARL CASE, Wellesley College: Well, the Fed very rarely overtly acts out of political motives. It, it also tends to not act on the basis of short run moves in the stock market or the financial market. I think what the Fed is doing today is looking at the economic pictures and the economic data, and the economic data are suggesting that things are slow. The consensus forecast for next year is for less than 2 percent growth.
PAUL SOLMAN: Consensus means all the forecasters–
PROF. CASE: Averaged.
PAUL SOLMAN: –averaged. Okay.
PROF. CASE: But there’s a fairly narrow band right now, and the forecast is for 1.9 percent growth. Employment was down less month. The employment rate edged up. Capacity utilization went down.
PAUL SOLMAN: That means the amount of–the capacity that our factories have–
PROF. CASE: Right.
PAUL SOLMAN: –and the utilization is how much it is used.
PROF. CASE: Right. Factory orders were down, so when you look at the broad brush of economic numbers, they’re pointing to a slow 1996, and there doesn’t seem to be any concern with inflation on the Fed’s part. The yield on the long bond which reflects people’s worries about inflation is very, very low.
PAUL SOLMAN: What does that mean, a yield on the long bond?
PROF. CASE: Well, when you buy a bond, a 30-year bond say from the Treasury or buy a mortgage, for example, you’re loaning money for a long, long period of time at a very low interest rate today, and that means that you’re not worried about inflationary fires getting ignited down the line. So inflationary expectations are quite stable, the Consumer Price Index has gone up in two consecutive months. There was a little bit of bad news in the Producer Price Index, the Wholesale Price Index last month, but by and large, the Fed is acting out of a slow, slow picture, and no fears on the inflation front.
PAUL SOLMAN: So it tries to stimulate the economy by cutting interest rates.
PROF. CASE: Exactly right.
PAUL SOLMAN: So, Mr. Gallagher in Washington, you wash–you watch Washington for Wall Street. Was Wall Street surprised by the Federal Reserve cut today?
TOM GALLAGHER, Lehman Brothers: I think just a little bit. I think that some people had been expecting the Fed to wait until there was a budget deal before they would cut rates, and so those people, I think, were surprised, but I think that the budget has probably been off the radar screen for the Federal Reserve Board for a while now in terms of today’s meeting, so that if the Fed was just looking at the conditions in the economy, I think that was what justified the reduction in rates. Once there is a budget agreement that’s a–that represents serious deficit reduction and that has a high probability of enactment, say once Congress has passed it and sent it to the President, then I think the Fed will take another look, and you could see another reduction in interest rates related to budget action then, but certainly today was out of the question.
PAUL SOLMAN: So you weren’t surprised by what happened?
MR. GALLAGHER: No.
PAUL SOLMAN: And you, Prof. Case, were you surprised by what the Fed did today?
PROF. CASE: No. I would have been surprised if it had gone the other way.
PAUL SOLMAN: Okay. So now, Mr. Gallagher, the stock market went down 101 yesterday, up 34 today. What’s going on, briefly, if you would?
MR. GALLAGHER: Sure. It’s always hard to try to explain market news, especially on a day-to- day basis. But I think that yesterday and today point to how Washington can be important in the financial markets, and yesterday stocks went down mainly because interest rates went up. Interest rates rising are bad for stocks because it means a slower economy, which means bad corporate profits. It means there are more attractive investments for investors to put their money in other than stocks, and for other reasons. So the question is–
PAUL SOLMAN: Why, why did interest rates go up?
MR. GALLAGHER: Well, the reason interest rates went up was that Wall Street had been anticipating favorable action on the budget. In fact, a lot of investors had been very complacent about the action in Washington. Last Friday’s breakdown of the budget negotiations, I think, shook that complacency so one of the reasons that interest rates have been going down was called into question, and that’s why interest rates rose yesterday.
PAUL SOLMAN: Okay. So now, Professor Case, what’s your take on, on the stock market reaction here?
PROF. CASE: Well–
PAUL SOLMAN: Is that–has he got it right?
PROF. CASE: I think he’s got it exactly right. The other thing to point out, though, is the stock market is at record levels really in the last few weeks, and it’s at record levels, in part, because the Fed is doing such a good job. We’ve had three years of sustained growth without inflation. The Fed is cranking up a little bit here, cranking down a little bit there. But we’re on a growth path that we haven’t been on in thirty, thirty-five years, which is 2, 2 1/2 percent, which is sustainable without inflation, and that’s an extraordinary record.
PAUL SOLMAN: Mr. Gallagher, does Wall Street see it that way, if you’re watching Washington there, you’re watching things like these, variables like this, is that how you see it? I mean, same as the economists?
MR. GALLAGHER: Oh, that’s right. No. I think that Prof. Case has it right. That’s the way Wall Street is looking at it. There’s a high degree of confidence in the way the Fed under Chairman Greenspan has been operating. And I think that’s why you saw the rally in the markets today. Lower interest rates are good–is good for the economy, good for corporate profits, and so you had stocks rising actually almost 50 points from the time when the Fed announced its action, so I think there’s a lot of confidence in the way the Fed is handling monetary policy.
PAUL SOLMAN: You mean, it was down a little bit today, and it then went up 50 points from where it was down?
MR. GALLAGHER: Exactly, exactly.
PAUL SOLMAN: Now, is the common wisdom, Mr. Gallagher, that a continuing budget impasse would spook the markets the way it did yesterday, or now that we’re hearing about a deal, that a deal would boost the markets even more than they’ve been boosted today?
MR. GALLAGHER: I think that’s right. I think, again, you focus on interest rates, what will interest rates do. If you get a credible deficit reduction package, that means lots of benefits for lower interest rates. The federal government is going to be borrowing less, so long-term interest rates will drop, and, again, if it’s a credible package, the Federal Reserve could engineer another decrease in short-term interest rates. So that’s good for the bond market, and, in turn, that’s going to be good for stocks.
PAUL SOLMAN: And now from the economics community point of view, a deal boosts stocks even higher than they are?
PROF. CASE: Absolutely. I mean, it’s, the markets love low interest rates, and when the Fed, when the Congress comes to agreement with the President and doesn’t have to go back to the credit markets and borrow more money, the less borrowing, the lower rates can go, and the more the Fed can then stimulate to create growth in the private sector. So it’s a contraction of the public sector and expansion of the private sector. And the stock market loves it.
PAUL SOLMAN: But the stock market loves it even though you’re saying that the Fed is worried that the economy is slowing down, and that’s why it’s trying to stimulate. That’s, I think, something that people have difficulty understanding.
PROF. CASE: But getting a little bit off the growth path is a little bit different than changing the fundamental budget process in the United States, and I think we’re a little bit off the growth path now, and we can get back on it.
PAUL SOLMAN: Off the growth path means a little below.
PROF. CASE: A little bit below the growth path, but that’s–that happens. I mean, the Fed can’t keep us exactly on, on line. So I think the fact that the economic numbers are a little slow, that the inflation is under control, the fact that inflation is under control, of course, is a good thing, and the fact that we’re a little, a little slow is not anything to be concerned about.
PAUL SOLMAN: And what’s the impact on the average person, the Fed lowering interest rates today, and what–
PROF. CASE: Well, if you’re a borrower, you like low interest rates, and if you’re–if you’ve got money in savings accounts and bonds, you don’t like lower interest rates; you like higher interest rates. So some people win, and some people lose. But the real key is that when interest rates go down, it stimulates economic activity and leads to long-run economic growth.
PAUL SOLMAN: And is that how you see it, Mr. Gallagher? I mean, how does Wall Street–again, we’ll put you in the role of looking at it as Wall Street looks at it–I guess that’s what you’re paid to do anyway. I mean, is, is that how you see it, some winners, some losers when the Fed cuts, or should we generally be happy, which is what I would have thought my reaction was supposed to be?
MR. GALLAGHER: No. I think it is. I think it’s generally positive. There may be some isolated groups that aren’t hurt by it. But let me inject one other thought on the budget debate in here because this discussion kind of presumes that the Fed will cut rates again when the Congress and the President agree on a budget deal. I think an important consideration is going to be to look at the details on that agreement, how serious is the deficit reduction, how credible is it, how much of it is occurring early on, as opposed to in later years when it might not materialize? I think that’s going to be the real question for the financial markets once they resume negotiations. We’ll have to look at the details very closely.
PAUL SOLMAN: And do you agree? Just a last comment, if you would.
PROF. CASE: Completely agree.
PAUL SOLMAN: Well, we have complete agree here, so, gentlemen, thank you both very much. We’ll leave it at that.