Fed cut hinges on size

March 19, 2001: 4:37 p.m. ET

In central bank's next move, the question is 'how much?
By Staff Writer Jake Ulick

NEW YORK (CNNfn) - The Federal Reserve is expected to cut interest rates Tuesday for the third time this year to keep the U.S. economy from slipping into its first recession in a decade.

But economists are divided over whether the central bank lowers borrowing costs by a half-percentage point, or the bigger three-quarter point cut that many hard-hit stock investors crave.

A slowdown that began last summer threatens to end a record 10-year economic expansion. But in a new twist for policy makers, a period of record stock ownership among Americans has coincided with a suffering stock market.

That's tweaked the argument over whether the central bank should respond to equity losses that, because they may influence consumer spending, could become a bigger-than-ever drag on the economy.

John Lonski, economist at Moody's Investors Service, hopes that the Fed lowers rates by three-quarters of a percentage point to purge the market of its "irrational pessimism" that threatens the expansion.

"If the Fed only (cuts by half a percentage point), it risks putting downward pressure on equity prices," said Lonski. "The Fed is dealing with the unknown of how much more pervasive stock ownership is today."

But William Sullivan, a money market economist at Morgan Stanley Dean Witter, forecasts a half-point reduction by policy makers concerned, but not alarmed, by weakening growth.

Sullivan puts the chance of a larger cut at only one-in-seven, in part because of the central bank's unwillingness to appear that it stands ready to bail out the stock market.

The Dow Jones industrial average, which suffered its worst weekly point loss last week, tumbling 821 points, could use a bailout.

"I hope it's (three-quarters of a percentage point) because that's what I think the market is really looking for," Nick Angilletta, global head of retail sales at Salomon Smith Barney, told CNNfn's The Money Gang.

Cheaper money
But despite the stock market's increasing ties to the economy, the so-called "wealth effect," though intuitively logical, is difficult to prove.

"It's hard to quantify," Morgan Stanley's Sullivan said.

Either way, with consumer and business spending slowing, lower interest rates could eventually cut the cost of mortgages, credit card payments and car loans and turn around Corporate America's weakening profit outlook.

Steven Wood, economist at FinancialOxygen.com, is calling for the larger rate cut. Still, he points out that Alan Greenspan, the Fed chairman, can wait to lower borrowing costs later this year if needed. The Fed meets again in May.

"The deterioration in economic activity would argue for a more aggressive move, but the Fed has rarely moved by more than (half a point) during Greenspan's tenure," Wood said.

Tuesday's meeting comes after a busy January. The central bank cut rates by a half-percentage point on Jan. 3 and again on the 31st, bringing the federal funds rate that banks charge each other for overnight loans to 5.5 percent.

In a Reuters survey, 14 of 25 primary dealers of U.S. government securities expect the policy-setting Federal Open Market Committee (FOMC) to lower its target rate by half a percentage point. But the other 11 firms forecast a three-quarter point cut.

When it comes to the rate debate, no one disagrees that the economy has weakened. During the final three months of 2000, the nation's gross domestic product fell to its lowest levels in 5-1/2 years.

Corporate profits have tumbled and equity prices have followed. The Nasdaq composite index is down more than 62 percent from its record high hit last year, and the S&P 500, a broader index, is in bear market territory for the first time since 1987.

The market losses could crimp the confidence and spending habits of American consumers who have poured trillions of dollars into stocks during the 1990s and whose spending accounts for about two-thirds of gross domestic product.

Some parts of the economy have held up well. The unemployment rate in February held steady at 4.2 percent, nearly a 30-year low, while the housing market has stayed relatively strong.

And one measure of consumer confidence showed strength Friday. The University of Michigan's barometer of consumer sentiment came in slightly higher than expected in March. But on the same day, industrial production again weakened.

The latest Newsweek poll, released Monday, showed that 71 percent of U.S. adults now think a recession is very or somewhat likely over the next year. That's up from 54 percent in December.

Japan's economy, the world's second largest, remains stuck in recession. And the U.S. dollar is strong, making it tougher for multinational companies to grow profits and for exporters to sell their goods aboard.

There's one problem the Fed doesn't face: inflation. Retail and wholesale prices have been relatively contained, making the job of cutting rates easier.

Back to the past
A half-percentage point cut by the Fed would take the federal funds rate to where it was in June 1999, just after the Fed began a year-long series of rate hikes that ended in May, 2000. Some say that last increase went too far, but Greenspan, speaking to Congress last month, defended the move.

The Fed's announcement should come Tuesday afternoon. Stocks headed higher ahead of the decision.

Some fret that a cut of half a percentage point could disappoint a stock market that has fallen since the Fed first rate cut in January.

Al Goldman, chief market strategist at A.G. Edwards, says the central bank's accompanying statement Tuesday, because it is forward-looking, may be as important as what the Fed does.

Speaking to CNNfn's Market Call, Goldman said a message indicating the Fed stands ready to do what it takes to turn the economy around may be crucial to whether stocks begin the speedy recovery that investors want.

If the Fed shows it's concerned about the economy, "the market should like it," Goldman said.

In the short term, the market reaction to Tuesday's moves is tough to call. But in the long term, history is on the Wall Street's side. Stocks almost always rise during a period when the Fed cuts rates.