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06/27 14:12

Fed Cuts Overnight Rate to 3.75%, Cites Risk of More Weakness

By John Cranford

Washington, June 27 (Bloomberg) -- Federal Reserve policy makers lowered the benchmark U.S. interest rate a quarter percentage point, an action that suggests they expect the economy to rebound and don't want to risk stoking inflation by reducing rates too much.

Fed Chairman Alan Greenspan and his colleagues on the Open Market Committee reduced the target rate for overnight loans between banks to 3.75 percent, the lowest in more than seven years.

Today's cut was smaller than the five half-point reductions that preceded it this year. Still, central bankers warned the economy faces a risk of continued weakness, suggesting lower rates are possible if growth doesn't pick up.

``The patterns evident in recent months -- declining profitability and business capital spending, weak expansion of consumption, and slowing growth abroad -- continue to weigh on the economy,'' the Fed said in a statement accompanying its decision.

Commercial banks probably will trim borrowing costs for consumers and businesses immediately, helping to boost growth that stalled late last year and so far shows few signs of rebounding. Since the first of the year, the Fed has reduced its target rate 2 3/4 percentage points in an effort to keep the slowdown from worsening.

The Fed's Board of Governors also voted to cut the discount rate on loans to banks from the Fed system by a quarter percentage point to 3.25 percent. Although few banks borrow directly from the Fed to meet their cash reserve requirements, the central bank generally keeps the discount rate within a half point of the overnight bank rate.

Analysts' Expectations

Analysts and investors weren't convinced the Fed would cut the overnight rate today as little as it did. Of 65 economists surveyed by Bloomberg News, 33 expected a quarter-point cut and 32 were looking for a half point.

Today's action takes the overnight lending rate to the lowest since it was 3.75 percent in May 1994. It may take six to nine months for the full effect of the Fed's rate reductions to work through the economy, economists said.

``There's no question that there's a lot of economic weakness, but that's a consequence of what's happened in the past,'' said Mickey Levy, chief economist for Banc of America Securities in New York. ``It's time for the Fed to be patient'' and let the reductions of the last six months take effect.

Cut Too Much

Some Fed officials have expressed concern that rate cuts may go too far. ``We probably don't have to worry about inflation for a while,'' said Fed Governor Laurence Meyer, who is regarded as a hawk on the dangers from accelerating price increases, on June 6. Still, he said, the Fed will ``have to pay more attention to overshooting.''

Central bankers have repeatedly said they had to alter their approach this year as the economy cooled more abruptly than anticipated following a series of interest rate increases in 1999 and 2000. ``The Fed has responded very aggressively and toward the end of this year or the beginning of next year, I expect to see some impact from that,'' Vice Chairman Roger Ferguson said June 14.

Six reductions since Jan. 3 constitute an unprecedented effort by Greenspan's Fed to kick-start an economy that grew from October-March at the slowest six-month pace in almost 10 years. Never before has Greenspan engineered so large a reduction in the overnight rate in so short a time, including the 1990-91 recession and its aftermath, when the Fed took more than a year to reduce the rate so much.

`Right Direction'

``I'm not expecting that we'll be getting back to what I would consider to be rapid growth by year end,'' San Francisco Fed Bank President Robert Parry said June 14. ``But I think we will be moving in the right direction by year end.''

So far, the economy has shown few signs of reacting to lower rates.

Following the fourth of the Fed's cuts, in a surprise decision April 18, investors bet the economy was on the road to recovery. Stocks gained and the Treasury's 10-year note fell, pushing up its yield.

That view has since evaporated. Since the Fed's fifth rate reduction on May 15, stocks have turned down. The Dow Jones Industrial Average has fallen 4 percent and the Nasdaq Composite Index has dropped almost 3 percent. The yield on the 10-year note has fallen about a quarter percentage point.

Factory Slump

The latest economic reports show a persistent slump in manufacturing. Production at factories, mines and utilities fell 0.8 percent in May, the eighth straight decline, the latest Fed figures showed. Factory production alone fell 0.7 percent, the largest drop since January, as makers of chips, computers and electronic components reduced worker hours to keep stockpiles in line with receding demand.

Retail sales rose just 0.1 percent in May after a 1.4 percent increase in April. More people are filing for unemployment benefits than at any time in almost nine years. Consumer confidence, which slumped at the beginning of the year, has gained the last two months. Still, the Conference Board's index of confidence for June is lower than the average for each of the past four years.

One of the most serious concerns cited by Fed policy makers is a slump in business spending for new equipment that is designed to make companies and workers more productive.

Business investment in equipment and software decreased at a 2.6 percent annual rate in the first quarter, after a fourth- quarter drop of 3.3 percent. The back-to-back declines were the first since the 1990-1991 recession.

Computer Demand

Greenspan said last month that the forces constraining investment are ``fizzling out.'' Soon, demand for computers, telecommunications gear and software ``should again strengthen,'' he said. For now, surveys show company executives plan to invest less on new equipment this year than last.

Makers of computers, chips and electronic components reduced worker hours in May to keep inventories in line with receding demand. The computer market ``has gone from slow growth to no growth quite quickly,'' said Anne Mulcahy, president of Xerox Corp., on June 14. ``It would be fair to say we're not counting on a turnaround of the economy to deliver our expectations.''

Even so, while today's Fed statement suggested policy makers aren't ruling out further rate reductions, analysts are beginning to doubt there will be more than one more quarter-point cut unless business investment slumps further or consumers curb their spending.

Before the announcement, trading in fed funds futures contracts suggested about a 50 percent probability of a quarter- point reduction today and a combined half-point cut by the Aug. 21 Fed meeting.

-- (M@rket.trends), June 27, 2001

Answers

I think the Fed made a mistake today. The cut won't help but makes stockholders feel good. Problem is that given inflation corporate borrowing is actually at 0% now. Japan by the same standard has corporate borrowing below 0% with no takers. Stupid protectionism. Borrowing rates are a very usefull tool for controlling inflation but can't save companies (or economies) that simply have some serious wringing out to do. We've still got a fair amount of 90's fat to trim and it's better to trim the marginal corps than endanger banking. Not to worry. Well run corps will again lead to good gains but there just won't be as many of them left.

-- Carlos (riffraff@cybertime.net), June 28, 2001.