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The stock market has become preoccupied with the possibility of another interest rate cut by the Federal Reserve Board. Some think lower rates are all that is needed for stocks to finally bottom and start to turn around. It's a bit more complicated than that.
While a Federal Reserve rate cut here in the United States will lower existing financing costs, it won't stimulate new lending. Why? Because of the level of outstanding corporate debt -- nearly $5 trillion, or 48 percent of gross domestic product in last year's third quarter -- and hits suffered by banks and financial services companies following bankruptcies of Global Crossing, K-Mart, Enron and Worldcom. Banks are reluctant to throw good money after bad.
Lower rates will help corporations restructure their existing debt. Lower rates will continue to support the housing market and the auto industry, the two main engines driving this economy. Lower rates will help the dollar, relative to other currencies, as the expected pick-up in economic activity will rekindle international interest in dollar-denominated assets. Lower short term rates will, perversely, drive longer term rates higher (that positively-sloped yield curve) in anticipation of more economic activity.
But lower rates can't force banks to open up the credit lines.
Paul McCulley, managing director at Pacific Investment Management Co. and one of last week's roundtable guests, suggests the government look at two things to help our economy.
One, look for ways to boost purchasing power. Specifically, there should be a holiday in the very regressive payroll tax. That type of tax cut would help those that tend to spend: lower and middle income Americans.
Two, the Federal Reserve should convince the banking system to open up lending spigots. McCulley says that currently, banks are shirking the responsibility that goes along with their privileges: FDIC insurance; the ability to go to the Fed's discount window and borrow money cheaply; and not having to "mark-to-market" or adjust the valuation of a security or portfolio to reflect daily market values. If banks won't lend money, McCulley suggests that the Fed should become very public with their request. Use the bully pulpit that goes along with the role of being the nation's central banker, or threaten to take away the aforementioned privileges. The alternative to lending more money is throwing BBB corporate America (issuers of the lowest level of investment-grade corporate debt) into a tailspin, if not bankruptcy.
Just take a look at what's going on with the world's second-largest economy, Japan. Short term rates are virtually at zero. The Bank of Japan, the Japanese central bank, cut interest rates in an effort to stimulate consumer demand and its economy, suffering its fourth recession in 10 years. But Japan is still saddled with an aging population, rising unemployment and a poor corporate profit picture.
Japanese businesses are usually less profitable than their U.S. competitors, mostly due to rigid labor practices that lead to higher costs. The Japanese banking system is overloaded with non-performing loans. These bad debts have been uncovered through stricter audits by regulators (sound familiar?), and while the banking system goes through this painful period, a decrease in lending is apparent.
Until Japanese financial institutions start lending money to corporations once again, their economy will remain in the doldrums and the Bank of Japan virtually impotent in its efforts to jumpstart the economy.
So the Fed can cut rates to 1 percent by the end of the year, as has been widely circulated in the market place. But unless it uses its latent power of persuasion on banks to lend to corporate America, this economy will continue to sputter, investors will continue to be skittish and the weight will fall on consumers. And they're gradually becoming weary of carrying the burden.
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