Will the Fed Rate Cut Be Enough?

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
November 19, 2002

IN THIS ISSUE:

1. The Fed’s Surprise Rate Cut.

2. The Economy – Is It Time For More Stimulus?

3. Consumers Increase Spending In October.

4. Lawrence Kudlow’s Latest Thinking.

Introduction

On November 6, the day after the Republicans swept the mid-term elections, the Fed slashed short-term interest rates by 50 basis-points (one-half percent). The key Fed Funds rate was cut from 1.75% to 1.25%. While the 50 basis-point rate cut came as a surprise to many, it should not have surprised anyone who reads this E-Letter or my monthly Forecasts & Trends newsletter. The highly respected and widely followed Bank Credit Analyst has been calling on the Fed to cut interest rates by 50 basis-points for the last two months.

[The Fed Funds rate is the rate of interest that banks charge each other to borrow or lend on an overnight basis. The level of the Fed Funds rate influences all other short-term interest rates. Lowering the rate is an incentive for banks to lend and businesses to borrow.]

The latest cut in rates is a clear signal that the Fed is worried about deflation catching hold in the US. This is good. The Fed has a tendency to wait too long before reacting to a potential problem such as this. By cutting rates 50 “bips,” the Fed signaled that it is well aware of the deflationary threat. The question is, will the latest rate cut be enough to give the economy a boost? I think the answer is yes, but even if it isn’t, there’s plenty more the Fed can do if need be.

This week we will look at this issue and also why there may be some good news amidst all the disappointing economic reports we’ve seen over the last two months.

Why The Larger Than Expected Rate Cut?

When the Fed announced the 50 bips rate cut on the day after the election, they also indicated that their rate “bias” had shifted from lower rates to neutral. Most analysts read that to mean that the Fed has no plans to cut rates further in the future. But as I will discuss below, the Fed is more than prepared to cut rates further if need be to stimulate the economy.

Fed chairman Alan Greenspan spoke to Congress on November 13, at which time he shed some veiled light on the Fed’s latest thinking. Officially, he said that the larger than expected rate cut was an insurance policy against a “significant decline” in the economy. If the economy does not decline, he said, the interest rate cut could be reversed. This led most analysts to conclude that we are at the bottom in interest rates. But that’s not the end of the story.

The Fed’s official position is that the economy is going to begin a slow recovery soon, especially with the latest rate cut. Here’s what Greenspan told the congressional Joint Economic Committee:

“The economy’s most likely projection is to come out of this soft spot and to start accelerating.”

The 50 bips rate cut is the Fed’s way of making sure, it hopes, that Greenspan’s forecast actually comes true. More importantly, it signals that the Fed is very aware of growing deflationary pressures and is prepared to take even more steps if necessary to keep deflation in check. In a speech on November 12, Fed vice-chairman Roger Ferguson stated that more interest rate cuts and other stimulative measures are still possible if necessary to keep the economy in positive territory.

More Fiscal Stimulus May Be On The Way

With the economy slowing down, there is increasing talk of the government adding more fiscal stimulus in the weeks or months ahead, especially now that the Republicans have control of both houses of Congress. In his latest testimony, Chairman Greenspan hinted that he might not oppose such fiscal stimulus, especially if the economy remains weak. While it is impossible to know exactly what the Bush administration may propose in the way of fiscal stimulus, here are some of the items on the table.

It is widely expected that the Bush administration will push for making the tax cuts permanent. They may also try to accelerate back-loaded income tax cuts to put more money in the hands of consumers sooner. The administration could also seek to end the current double taxation of dividends, as well as the alternative minimum tax. This coupled with a reduction in the capital gains tax rate, which is also under consideration, would give a much needed boost to investors and the markets. An end to the estate tax – or “death tax” - is also a real possibility.

Some Good News – Consumers Still Spending

While consumer confidence and spending have been on the decline the last several months, there was some good news in October. The latest survey of major retailers showed sales up 3.1% in October. This was a positive surprise and suggests that holiday shopping may not be nearly as bad as many have suggested in recent weeks.

The Commerce Department also reported last week that business inventories rose 0.5% in September. This was also a surprise. Because inventories were higher than expected in September, it now looks likely that the government will increase its estimate of 3Q GDP in the next report. While some are expecting the next estimate of 3Q GDP to be lowered, they may find that it is actually increased instead.

Unfortunately, that’s about all the good news there was over the last week. On Friday, the Fed reported that industrial production fell 0.8% in October. That number was worse than expected and followed declines of 0.2% in August and September. The October number was made worse by the recent lockout of the West Coast ports. Some factories had to shut down or curtail production due to parts shortages.

With most analysts expecting growth of only 1-2% in the economy in the 4Q, expect to see more mixed economic reports for the remainder of the year. Without any major negative surprises, it still looks like a recession will be avoided.

Lawrence Kudlow - “A Surprise For The Pessimists”

Larry Kudlow is an economist, a syndicated columnist and a frequent guest on financial talk shows. I enjoy reading his work, although I don’t always agree with him. In his pre-election column, which follows (reprinted in full), he makes some interesting points about the economy.

“America's resilient, durable, flexible, market-driven economy - which features the lowest central-planning influence of any of the 30 major world economies - continues to surprise the pessimists.

With numbers now in for third-quarter gross domestic product, the U.S. economy has maintained a solid, if unspectacular, recovery over the past year. It has grown at a 3 percent rate, with 3.6 percent growth in the domestic economy (real gross domestic purchases), since the end of the recession a year ago. That’s solid. The unspectacular part is that first-year recoveries have typically run in the 5 percent to 7 percent range. But let’s be thankful the American economic machine is in fact growing at all.

We can't forget that the onset of war a little more than a year ago, in the wake of the terrible bombings of the World Trade Center and the Pentagon, virtually closed down U.S. commerce and financial operations for a time. So, in producing 3 percent growth, America has performed admirably.

This should shutter partisan arguments that President Bush has failed on the economy.

Of course, the Democratic Party, in full-campaign stride, is out painting a picture of an ever-present and terrible recession. But a combination of modest tax cuts and a monetary nudge from the Fed has helped generate economic recovery instead of a widely forecast and prolonged downturn. The consensus of economists who made that recession forecast following the terrorist attacks gave new meaning to the term dismal science. And they were dead wrong.

The pessimists also missed on the technology sector. While tech stocks have taken a lot of the heat for the worst stock-market correction in decades, rapid productivity gains from the application of technological advances continue to work inside our $10.5 trillion gross domestic product (GDP). Share prices for tech-based companies have faltered, but this sector is now sending out signs of recovery.

In the new GDP report, business investment in equipment and software increased 6.5 percent at an annual rate in the third quarter - its best performance in 2½ years. Business spending on durable goods increased 23 percent annually. Computer sales are up, rising at a 75 percent annual rate in the most recent quarter. Wireless is doing well, with top-line sales and profits at Nextel, Verizon and AT&T coming in surprisingly robust. And customer demands for cable and broadband are spiking, if Comcast is any measure of performance. In short, the tech sector is waking from its long sleep.

And so is the stock market. With overall corporate profits rising roughly 20 percent in the third quarter, backed by a 3 percent growth-trend in the overall economy, the U.S. stock market has now established a firm base from which future increases can no longer be in doubt. The only thing in doubt is the speed at which we are capable of growing. And to figure that out, we may have to look to Washington.

If Congress and the White House return growth-minded from next week’s election, they can get right to work by eliminating the double and triple taxation of dividends and other forms of investment. Such a policy action could put profits from the sale of stocks and homes on an equal footing where they belong. Next, new business start-ups, which are the engine of employment, should be made tax-exempt in their early money-making years, and then taxed at half the normal rate for a few years thereafter.

Growth-minded policymakers should also speed the arrival of the Bush income-tax cuts passed in 2001. More, they should make permanent the across-the-board tax-rate-reduction program and the 30 percent cash-expensing bonus for business write-offs of new equipment. Finally, the Federal Reserve should be encouraged to inject more cash into the economy. This would stabilize business prices, finance growth, and improve our potential to expand.

On the other hand, there's always a risk that policymakers might embrace the Great Society leftover plans now being suggested by numerous Democrats on the campaign trail. This would be a stupid step backward in history toward liberal Keynesianism. But the likeliest voters - those who are shareholders and business owners - can be counted on to reject the antigrowth consequences of increased spending and higher taxes.

Surely the prosperity of the past two decades has proven that business investment is the key to growth. It is our businesses that create jobs and the income that sustains consumer spending. But capital formation is essential to those businesses. We must strive to make the tax cost of business capital in the U.S. the lowest in the world.

And let's not forget, a vibrant economy at home is necessary to produce the military and national-security resources that are so essential to the spread of freedom and democracy to the darkest corners of the world.”

Again, I don’t agree with everything Larry Kudlow has to say. Certainly, his case that the stock market has nowhere to go but up is questionable. But with regard to the economy, he makes some excellent points. Who would have thought a year ago that it would have grown by 3% over the last 12 months? But it has. What a tribute to this great nation we are blessed to live in!

Best wishes,

Gary D. Halbert

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