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The success of the Federal Reserve Boards dramatic half-point reduction in interest rates last week will depend on how much it shores up deteriorating consumer and business confidence in the economy.
And business-oriented tax cuts may still be needed to back up the Feds action, according to economists.
“The key issue is what it does to confidence,” said Anirvan Banerji, director of research at the Economic Cycle Research Institute in New York.
The surge in the stock market that followed the Feds action indicated that it was working, at least initially. “This was a very aggressive move to head off an impending slowdown and to buy a little insurance against the economy slipping into a recession,” said Marty Regalia, chief economist at the U.S. Chamber of Commerce. “Monetary policy is a little bit of a laggard, and moving as quickly as they did and as much as they did should help shorten that lag.”
Still, he said, “The economy needs a tax cut. Running surpluses tends to dampen the economy. That is great when the economy is growing 5 percent, but not when growth is down to 1.5 percent or 2 percent.”
The Nasdaq Composite Index rose 14.17 percent, or 324.82 points, to 2,618.68 — the largest increase in its history — when the cut was announced Wednesday, Jan. 3. Volume on the Nasdaq was 3.12 billion shares, the largest in the systems history. The Dow Jones Industrial Average was up 2.9 percent to 10,945.75, its highest level since September 2000.
Economists said the Fed reacted because stock markets last Tuesday continued the fall that had accelerated in November and December, and because the National Association of Purchasing Managers said Tuesday that manufacturing growth was at its lowest level since 1991.
“Until we got that report, there was not much hard evidence that there was an excessive slowdown,” said Ken Matheny, senior economist at Macroeconomic Advisers, a St. Louis consultancy. “That report usually gets the Feds attention.
“They are saying they are on the case and are prepared to take swift action to improve confidence and to reassure investors they will not let things get out of hand. It was by acting so quickly and making a 50-basis-point cut that they have done what they could to restore consumer confidence,” he said.
If business and consumer confidence does not improve by the middle of March, there may be a need for tax cuts to stimulate the economy, Matheny said.
Alan Greenspan, the Fed chairman, arranged a conference call with board members around the country and pushed through the reduction, which is twice as large as the 25-basis-point cut he usually favors. The funds rate is what banks charge each other for overnight lending. The Fed also reduced its discount rate on its loans to banks by 25 points to 5.75 percent, and said it is ready to cut that rate again by another 25 points.
A change in the funds rate usually takes six months to nine months to filter into the economy, and the Fed has been blamed for contributing to the slowdown with six increases in the rate over the previous 18 months, most recently in June 2000.
Last weeks rate reduction may affect companies that borrow money on variable rates if banks adjust their prime rates, Regalia said. Two major banks immediately announced that they would, and more were expected to follow suit.
A week before the Fed announcement, Kevin Hassett, resident scholar at the American Enterprise Institute, had predicted a 50-basis-point cut, and a cut of as much as 150 basis points over the next six months. “There is a lot of room to cut rates, and that would go to the bottom line, for instance, of companies that use short-term debt,” he said. He also predicted that Congress will give President George W. Bush a tax cut of $700 million to $900 million.