Time for the Fed to Cut Interest Rates

The Washington Post, Tuesday, August 23, 1998; Page A15

While the gyrations of the stock market grab headlines, the biggest financial news this summer has been the dramatic decline in long-term interest rates.

On Friday, the yield on the Treasury's 30-year bond hit an all-time low of 5.38 percent—down from 6.08 percent just four months ago.

Low rates are usually good news. They mean cheaper mortgages for consumers and decreased borrowing costs for the government and corporations.

But rates today are not really as low as they seem. After adjusting for inflation, long-term rates are high, and short-term rates are even higher—the highest in nine years.

In fact, interest rates are becoming a drag on the economy at a dangerous time—just as the financial crisis that has infected Asia and Russia is beginning to hit the United States.

I think there's a strong case for the Federal Reserve to "ease"—that is, cut rates—when its Open Market Committee meets again next month. The longer the Fed waits, the closer a serious slowdown, or recession, becomes.

But don't take just my word for it. Bob Prince and Jeff Gardner of Bridgewater Associates, a respected research firm in Wilton, Conn., wrote clients yesterday, "The message has been pretty clear, but on Friday it got even clearer. The Fed needs to ease."

Also yesterday, Ed Yardeni, chief economist of Deutsche Bank Securities, sent a fax to clients, headlined, "Please Ease Now!" He told me yesterday, "I am publicly pleading with the Fed to lower rates."

And Brian Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson in Chicago, is calling for a cut as well, worrying that many companies "are losing ground as they fall behind in high-tech investment and pay painfully high real rates to borrow."

By buying and selling securities, the Fed regulates the overnight, or "fed funds," rate. That rate is 5.5 percent, where it's been stuck since March 1997, even though inflation is currently only 1.7 percent. By contrast, between 1992 and 1994, the fed funds averaged 3.5 percent while inflation was 2.9 percent.

"In reality," says Yardeni, "the Fed has been tightening by leaving the federal funds rates unchanged . . . as inflation plunged." The real, after-inflation short-term interest rate is now a hefty 3.8 percent—the highest since 1989.

During much of the 1980s, short-term rates were higher, but at the time the Fed was trying to wring a decade's worth of inflation out of the economy. That job has been done, admirably, by Fed chairmen Paul Volcker and Alan Greenspan. Now the Fed is risking a recession by reviving the high real rates of the past.

"The Fed," says Yardeni, "is still fighting the last war—inflation."

Declining long-term bond rates have created an "inverted yield curve"—with short-term rates higher than 30-year rates. Such an inversion, Caroline Baum of Bloomberg Business News reminds us, "is generally a sign of tight monetary policy and a harbinger of an economic decline."

Prince and Gardner see the U.S. economy as precarious. "Inventories are high, and growing too rapidly," they say. Industrial production is slowing. Meanwhile, commodity prices are crashing, with oil and gold at the lowest levels in a decade. Deflation, not inflation, is the threat.

Can't the Fed change course and cut rates if a slowdown becomes more evident? Maybe not. Wesbury quotes economist Joseph Schumpeter, writing in 1931: "It is easier to dampen prosperity by a high rate of interest than to alleviate depression by a low one." The Japanese have recently learned how right Schumpeter was.

So why does the Fed insist on high rates? We can't tell for sure, but Greenspan is clearly concerned about an overheated stock market. If rates are cut, the thinking goes, then stocks will soar—as they usually do when borrowing costs fall.

"We're in this ridiculous situation where the Fed is waiting for the stock market to go down before they can ease," says economist John Makin, my colleague at the American Enterprise Institute. Makin, who has been warning for a year of the dire deflationary effects of the Asian crisis, wants the Fed to cut rates now.

"Things are pretty ugly," he says. Much of Asia is in a depression. The Russians went through $23 billion in IMF dough in just weeks. Latin America is suffering. And lower consumer demand globally is hurting U.S. corporate profits.

A rate cut would help the world, not just the United States, say Prince and Gardner: "Nothing would do more to address the plight of emerging markets and Asia than a Fed easing."

The Fed, however, continues to be hung up on a stock market it believes to be overvalued. "Amazingly," says Yardeni, "the Fed is biased toward raising interest rates." However, he says, "with events coming unglued so rapidly, a cut in rates is conceivable by year-end."

But will that be too late?