Surprise Move by the Federal Reserve

RAY SUAREZ:

It's the first rate cut since November of 1998. Over the past two years, the nation's central bank has raised short-term interest rates five straight times. The idea was to cool down a U.S. economy that many observers considered overheated. But the Fed reversed course today and cut rates with no warning and no scheduled meeting of its monetary policy committee. In a written statement, the Fed cited weaknesses in several areas, including lower consumer confidence, tight conditions in financial markets and high energy prices sapping household and business purchasing power. Joining us now is Gail Fosler, chief economist at The Conference Board, a business research organization; Brian Wesbury, chief economist at Griffin, Kubik, an investment bank in Chicago; and George Hager, economics writer for USA Today.

Well, Gail Fosler, a lot of the business pages and headlines that have been coming out all afternoon have been saying surprise cut, surprise cut. Were you surprised either by the timing or by the size of the rate cut?

GAIL FOSLER:

I was surprised by both the timing and the size. I think the Fed took a very aggressive action here. I think it's interesting that they took it in advance of the Friday employment numbers because I think they really want to get ahead of any kind of decline and really affect expectations.

RAY SUAREZ:

Brian Wesbury, how about you?

BRIAN WESBURY:

Definitely there was a surprise. The Fed did not have a scheduled meeting and it happened before the employment report as Gail said — but in another way it wasn't a surprise. The economy has deteriorated rapidly in the last few weeks. We had a terrible number yesterday on manufacturing. And so something needed to be done and today's action was welcome in that regard.

RAY SUAREZ:

George Hager, what were people telling you today about what is behind this decision?

GEORGE HAGER:

Well, two things. One, as Brian just mentioned, the factory sector is really suffering. Their current index just came out yesterday — is just hovering right above the level at which the factory sector is so weak it could drag the whole country into a recession. Secondly, there is a question of confidence, investor confidence, consumer confidence, business leader confidence, and a lot of the people I talked to today said one of the reasons the Fed did what it did which was a big surprise to everybody was to sort of get everybody's attention and try to restore confidence.

RAY SUAREZ:

Well, Gail Fosler, you talked about trying to get ahead of this. Was a half point cut as opposed to the more common quarter point raise or lowering meant to have a psychological impact as much as a nuts and bolts macroeconomic mechanical one?

GAIL FOSLER:

I think it was definitely meant to have a psychological impact. It would take, you know, nine to twelve months for this to have any kind of real impact, but I think the Fed really wanted to show that it was going to stand behind the U.S. Economy as much now as it did behind the global economy in 1998.

RAY SUAREZ:

But do you think that the alarm bells that you just heard from Brian Wesbury are appropriate, or is there still a lot of underlying strength in the economy and this is more of a psychological move?

GAIL FOSLER:

Well, I think there – I mean, obviously, we did get an alarm bell in terms of the National Association of Purchasing Managers Report. But when you look at our consumer confidence index, The Conference Board's consumer confidence index, you see that really any weakness that we've experienced has really come from expectations. And the consumers are still experiencing a fairly strong economy. And that is really reflected by continued home buying, actually refinancing that is going on in the housing sector. And it looked like Christmas was a pretty good Christmas — not much to write home about — but still a good Christmas. And business spending still continues to be quite strong. So I think we were really acting on the expectation side.

RAY SUAREZ:

And Brian Wesbury, how do you respond?

BRIAN WESBURY:

I disagree with Gail a little bit there, actually a lot, and that is that the economy is slowing down significantly. The manufacturing survey that she mentioned, the National Association of Purchasing Managers Survey, has actually been below 50 or the breakeven point, showing a contraction in the manufacturing sector for five consecutive months. Housing really peaked late last year. Auto sales are down. Retail sales were weak for this Christmas and I think a lot of this has been because the Federal Reserve raised interest rates too far. They are behind the curve so to speak. In fact, market interest rates are much lower. The two-year Treasury yield today is 5 percent, actually 4.95 percent . And that says the Fed has a long way to go before they are actually back down to where the market is and where they can really help the economy.

RAY SUAREZ:

Well, George Hager, where do the people you are talking to come down on this market psychology versus market fundamentals?

GEORGE HAGER:

Well, they come down exactly where Gail and Brian just came down, and that is all over the place. The people I talked to say essentially the economy, the optimists say the economy is running, yes, a lot more slowly than it was but still cooking along at a pretty good rate, no where near recession; the pessimists say we are already in a recession. And the question of getting the psychological attention of especially business people, is a big one among the people I talked to today — in terms of motivation, what was motivating the Fed to do what they did.

RAY SUAREZ:

Well, let's talk a little bit about mechanics then. What does this rate cut really mean? I mean, we talk about it like it's a big deal and it's sort of implicit in all the reporting that it's a very important thing. When consumers, when business people head off to banks and money markets, starting tomorrow, what will be different there?

GEORGE HAGER:

I, well, one of the things is the prime rate is going to come down a half point. The prime rate moves in lockstep with the Fed fund's rate. The Fed fund's rate, remember, is just the rate that banks charge each other for overnight loans, its a very obscure little kind of a rate but it does have an enormous impact. And, secondly, though, you know, I talked to a bank economist today who pointed out one thing that is very interesting. He said usually there is a six, nine, even a twelve-month lag between the Fed taking action on interest rates and impact on the real economy, but what he reminded me was that banks are going to have an immediate impact on their bottom line. They're going to do a lot better. They are going to be willing, therefore, to make more loans to creditworthy consumers, and that was a big Fed concern – that credit would dry up.

RAY SUAREZ:

Go ahead, Brian.

BRIAN WESBURY:

Well, I was just going to say that it does take six to nine months for this to affect the economy.

RAY SUAREZ:

Why though? Why does it take so long?

BRIAN WESBURY:

Well, when the Federal Reserve lowers interest rates, what they're really doing is adding more money or liquidity into the economy. So, in effect, they don't have a switch on the wall that says we want rates down half a point, let's put them down. They have to do something to get that to happen. And what they do then is inject money into the system. And then it takes about six to nine months for that money to flow fully through the economy and have the full impact of a rate cut or have the full impact of that ease. That is why I believe that they need to do more in the months ahead in order to really get the economy out of this hot water — because we won't see any impact in the next six to nine months. I expect the Fed to cut rates another full percentage point over this next year. We will be down to 5 percent on the federal fund's rate by the end of 2001.

RAY SUAREZ:

Well, Gail Fosler, earlier today a car dealer told the NewsHour that just this move from this afternoon saved him $170,000. And there must be a lot of people like him. What sectors are particularly sensitive, what industries will find a lot to like about this one half of one percent reduction?

GAIL FOSLER:

Well, basically all the cyclical industries. I mean, the automobile industry has been very hard hit now. One of the reasons they've been hard hit was because they did so well early in the year. We had, we had unsustainably high rates of auto buying but I think they're going to be able to offer very attractive financing and be able to make money doing it, so we'll see more consumer purchases of big ticket items. We're certainly going to see more strength in the housing marked and we'll probably see business investment even pick up even more. This is really a very important shot in the arm.

RAY SUAREZ:

And do you agree with Brian Wesbury's one percent subsequent reduction forecast?

GAIL FOSLER:

No, I am, you know, I'm sorry, I'm kind of one of the ones that are on this optimistic side I guess in the sense that I think what we are seeing is something that is very serious, very acute but very short-lived in terms of the slowdown in the economy. I think the economy is still fundamentally very strong. I think what we would call the long end of the market, the 30-year bond rate, which really affects the mortgage rates that people pay, have been really stimulating this economy for sometime which is reflected in the very strong new and existing home sales activities. So I think the Fed already has interest rates doing a pretty good job for it. But I really think it wanted to just redirect people's attention away from recession and really get people focusing on growth again.

RAY SUAREZ:

So what would you, would we be looking for to see whether this has its intended effect and when would we see it?

GAIL FOSLER:

Well, certainly one indicator would be our index of, The Conference Board's index of leading economic indicators. The index of leading economic indicators reached a peak earlier this year. It has been pointing down. If we look at the, some of the impact likely impact of this rate cut, one could expect that our January numbers are going to show an increase. So I think that is going to be a very positive signal and of course consumer confidence, if we can bolster people's expectations about the future, I think we'll see that people will become more optimistic and the economy actually will turn in some better numbers than people expect at the moment.

RAY SUAREZ:

George Hager, during the time that the Open Market Committee was raising interest rates during 1999 and 2000, we were told that inflation was the big enemy of continued economic health. Did the Fed in its move today have much to say about inflation and whether it continues to be any kind of threat?

GEORGE HAGER:

Well, they said about as much as they usually say – a very short sentence saying that basically inflation is contained. This has been… absolutely right over the last few years. This has been their chief worry, and in fact, it wasn't until November/December that they decided that, gee, maybe the economy is going to slow more, and that should be our chief worry. Inflation, despite a lot of predictions that it would get out of control especially when the labor market got very tight, has been remarkably low. It is chiefly now, if you talk to people at the Fed, they say the one thing that worries them is energy prices. Already, oil prices are coming down, natural gas prices are still in the stratosphere, but oil prices are coming down and the forecast is for inflation to abate as we go forward this year.

RAY SUAREZ:

And, Brian, you wanted to say?

BRIAN WESBURY:

I was just going to say that, and this is where I think the Fed made a mistake. For a number of years now the Fed has believed that the economy can't grow 4 percent per year, cannot have unemployment at 4 percent without creating inflation. And that is what happened in 1999, they began to increase interest rates because they thought the economy was too strong and eventually those rate hikes did have the impact that they desired, and that is that it slowed the economy. Unfortunately, it slowed it too much, and now the Fed is trying to correct that mistake. And I disagree that this is all a consumer confidence or expectation development. This slowdown has its roots in real economic developments and the main one is that the Federal Reserve pushed interest rates up too far.

RAY SUAREZ:

Brian Wesbury, panelists, thank you all very much.