Fed Lowers Rates

MARGARET WARNER:

Did the Fed make the right call today cutting interest rates one half a point? Joining me to discuss that are: Henry Kaufman, President of Henry Kaufman & Company, an economic and financial consulting firm; Maureen Allyn, chief economist at Zurich Scudder Investments, a financial management company; and Mary Farrell, senior investment strategist at UBS PaineWebber, a financial services firm. Henry Kaufman, beginning with you, was this the right move today, a half-point rate cut?

HENRY KAUFMAN:

It was an inadequate move really. I think the Federal Reserve is acting belatedly and inadequately. I really feel the Federal Funds rate, which is now at 5%, should be much lower. It ought to be in the range of 4% to 4.5% in order to deal with the economic and financial situation.

MARGARET WARNER:

Maureen Allyn, how do you see it? Inadequate?

MAUREEN ALLYN:

I don't think it's quite that inadequate. I look at the credit markets, not just the stock market, and the credit markets have really begun to open up ever since the Fed's first rate cut. If they cut too much too fast, I think you'd just be getting yourself into trouble down the road. Greenspan has always been rather a gradualist. I think this is actually quite aggressive. They stand ready to do more if they think the economy or the financial markets need it.

MARGARET WARNER:

Mary Farrell, what's your view?

MARY FARRELL:

I'd just like to pick up on that last point. The most important thing today was the statement that accompanied that rate cut, where the Fed using language very similar to the language they used last December 19, that they would watch the evolving… or monitor the evolving financial situation with a view to acting, if necessary, and I think it's pretty clear that a half percentage point will not be enough, but I think also clear from the statement, they're prepared to act not without waiting for their two month-away May meeting.

MARGARET WARNER:

Henry Kaufman, how do you read the Fed's statement in it's always a little cryptic, but in terms of its reasons, was it responding to the markets, to the economy or to both?

HENRY KAUFMAN:

It tended to focus, first of all, on the squeeze on profits, and that would slow down investment spending. And for the first time, I think it highlighted that also there has been a decline in stock prices, which is going to restrain consumption. There is a belated recognition by the central bank that the euphoria in the financial market that has been deflated now is contributing to an economic slowdown. Now, that is quite important because the Federal Reserve, in recent years, as the financial markets were booming, never wanted to fully integrate the behavior of the financial markets into the behavior of economic activity.

MARGARET WARNER:

Maureen Allyn, do you think it's appropriate for the Fed… should the Fed be looking at the stock markets and basing their decisions in part on the performance of the markets?

MAUREEN ALLYN:

Well, I think they always should have been. In fact, Greenspan talked about doing that in 1996 and again in 1998 when… and the markets hated him for it. The markets said they shouldn't deal with the stock market at all.

MARGARET WARNER:

You're talking now about the time when he thought perhaps the market was irrationally exuberant.

MAUREEN ALLYN:

Precisely then. I always felt that he should be targeting. One of the big risks you take is if you do let a bubble develop, it does produce excess capacity, it does producer rational exuberance. It was his phrase. And then you can have a problem when it goes down very quickly. So I mean I think you always should look at the stock market. I think he is looking at it now, but he probably should have looked at it a little bit more closely back in '96 and again in 1998 and never let this thing get started.

MARGARET WARNER:

Warner: So what are you saying exactly? Are you saying that you felt that he should have actually tightened credit earlier?

MAUREEN ALLYN:

Absolutely. I think he should have had higher interest rates back when he was talking about it. But of course, that's always easy to say in hindsight. And now he has to deal with the fact that the market is down and it will do just as Henry Kaufman said, it's going to undermine confidence, it has left us with a legacy of some excess capacity. It's a very, very risky time right now. On the other hand, though, there's no, absolutely no need to panic because the credit markets have opened, companies can get loans, and I think that is going to lay the foundation already for better economic news sometime towards the end of the year.

MARGARET WARNER:

Mary Farrell, how do you see the relationship between the stock markets today and the economy, the fundamentals of the economy that we always talk about? In other words, do the stock markets reflect the health of the economy, or do they in some way also drive it?

MARY FARRELL:

It's a very intricate relationship and a very significant difference with the stock market today, versus a few decades ago. Back in the 70s, about 10% of Americans owned stock; today it's50% of American families and that means that the stock market is not isolated at all from consumer confidence. And in fact, I think confidence can be a very fragile thing, and for more people today are affected by the declines in the market, and that means their suspending is potentially affected. So we have a much more interrelated economy and stock market than we did sometime back.

MARGARET WARNER:

So does that mean that… do you agree with ms. Allyn that the Fed needs to look at the markets even though it's not in their historic sort of charge?

MARY FARRELL:

I think much more so than in the past. I think when the market was limited to a much smaller number of individuals, and primarily institutions, it was a very different thing to deal with. But today, I think that it does have a much larger impact than before, and that the Federal Reserve needs to take into consideration what the market is doing. But I would make a little bit of a distinction. The Fed's role is to deal with the economy, not the stock market. I'd be wary of a Federal Reserve that was responding to fluctuations of the market. We've seen unprecedented volatility in this market, and we look for the Federal Reserve to be a main stay, not to respond to that.

MARGARET WARNER:

And, Mr. Kaufman, how do you think that the Fed should calibrate this relationship between the markets and the economy and how much it should respond to the markets?

HENRY KAUFMAN:

Well, I strongly believe that the role of the Federal Reserve is to be the guardian not just of the economic system, but its main thrust is at the financial system. And in that sense, it has to recognize what some of the real structural changes have been. And as Mary has pointed out, in the 1990s, more and more Americans became direct investors in stocks. At the same time, an increasing number of American corporations bought back shares. This was a fundamental driving force in the American financial markets and subsequently on investment spending, on consumption, it created a bubble. And there was a failure by the Central Bank to recognize this change. Now, there were many instances when the chairman, for example, talked about irrational exuberance in 1996, but quickly pulled away from that. Back in… just a year and a half ago in 1999, at a conference, the chairman indicated, for example, that it's very difficult to recognize a bubble, but the Federal Reserve knows what to do about it once it bursts. The response thus far after the burst has been belated and has not been timely. We face in front of us a sharp contraction in investment spending by business, a slowdown, for example, in consumption after a while. And it isn't just an American phenomenon. If you look around the industrial world today, in Europe, in Japan, major financial markets, major stock markets are declining very, very sharply.

MARGARET WARNER:

Now, the stock markets here did not respond well to today's rate cut. Explain that. And why would it make such a difference to the markets whether it was three quarters of a point or half a point?

HENRY KAUFMAN:

Well, when you lower interest rates significantly, it is an admission that you're recognizing the problem fully. In addition, from an economic viewpoint, you lower the cost of financing. Households can refinance their mortgage at a lower level of interest rates, and that provides some spending relief. Business corporations, particularly marginal ones, which are paying much more than typical when they bond finance and even in the banking market, their costs of borrowing is reduced if you reduce the Federal Funds rate very sharply. This is not an instantaneous process, but it is a process that will kick into its effectiveness in a reasonably short time. The Fed did not do that today.

MARGARET WARNER:

Maureen Allyn, do you think today's market reaction, the Dow down,, what nearly 240 points, the NASDAQ nearly 100, was that a rational reaction?

MAUREEN ALLYN:

I don't think there's much rationality going on on Wall Street right now, and I don't think this their has been much rationality going on for probably a couple of years. I don't think there's anything the Fed could do at this point, even 75 basis points, that would have made Wall Street happy today. Let's face it; the stocks got extremely overvalued, and while we think they're pretty close to reasonable values now, many of them are still not cheap. And that is not the Federal Reserve's job. I agree with Henry Kaufman, their job is much broader than that, and they have to keep the whole financial system together. And I come back again and again, the financial system that matters is the bond markets, which are providing that finance and as Henry said, we are getting a flurry of home refinancings, which is already putting cash in people's pockets. If you go too far too fast, I think that's a risk, too. They will do more. The Fed is on record that they will do whatever they think they need to do to stabilize the economy and make sure that we don't have too rapid a slowdown. We're already going to have one. I mean this isn't going to work right away. It's definitely going to be a problem. But I don't think we ought to chastise them for that last quarter of a point they didn't do today.

MARGARET WARNER:

And, Mary Farrell, your view on that.

MARY FARRELL:

I think that it would have been a much stronger signal to Wall Street had they done the three quarters of a percentage point, or more, which was probably too optimistic to hope for. But it's very clear with the financial market's responses that the concern out there is for corporate earnings, and the belief with this… that this interest rate cut is not enough to spur that growth back. And ultimately, you know, we've been talking about… Maureen talking about rational markets or irrational markets, ultimately markets get priced based on the fundamentals. A year ago when the market was selling at much higher price earnings ratios, we had perfect fundamentals: Inflation, interest rates and earnings. Today, we have inflation under control, we have a better interest rate picture. But the problem is definitely corporate earnings, and that is going to hang over the market first quarter, second quarter and that's why we do need… We could have used a larger rate cut. We certainly hope for more rate cuts, because that will go a long way towards spurring those earnings. Once you get those earnings back on track, I think you can get the market back on track.

MARGARET WARNER:

So just so I understand, you're saying it's more than a psychological signal, that the markets really believe that, even another quarter of a point would have helped corporate earnings?

MARY FARRELL:

Yes, and the earnings picture is not particularly good. First quarter operating earnings for the S & P 500 are probably going to be down 9%; second quarter, down 4% to 5%, versus a year ago. That's going to be a definite pressure overhanging the market, and right now, the market's selling off because there isn't any confidence that we're going to have a turnaround. I think the earliest possible we could hope for good comparisons is the fourth quarter and that does require a better economic environment and a better one than a half a percentage point is likely to deliver. We need more.

MARGARET WARNER:

All right, well, thank you all three very much.