On four previous occasions this year, Federal Reserve Chairman Alan Greenspan and his central bank colleagues have slashed short-term interest rates by one-half percentage point, cumulatively reducing the federal funds rate to 4.5 percent from 6.5 percent. If the Fed waited too long to respond to the economys slowdown, the subsequent enthusiasm with which the Fed has cut interest rates has gone a long way toward compensating for any delay in its initial response. However, the Feds work on the monetary-policy front at this stage in the business cycle is not finished. When the monetary policy-making committee meets today, another one-half percentage-point cut is in order.
Reductions in the overnight interest rate immediately affect the prime interest rate, which directly impacts interest rates paid by businesses and consumers. With business investment dead in the water at the moment and likely to remain depressed for the balance of the year, nobody is arguing that another interest rate cut would reinvigorate the “animal spirits” of the business community. However, a reduction in corporate borrowing costs would ease the intensifying pressure on profits. According to Business Weeks Corporate Scoreboard for 900 companies, profits plunged 25 percent during the first quarter, reflecting the sharpest quarterly drop since the 1990-1991 recession and the second consecutive quarter in which profits fell at a double-digit rate.
Plunging profits, of course, further dampen capital investment, which, in the final analysis, will not increase appreciably until a sufficient expansion in consumer demand reduces the growing gap between capacity utilization and industrial production. Indeed, the Fed reported yesterday that industrial output fell 0.3 percent in April, the seventh consecutive month of decline. Meanwhile, factory capacity fell to 77.1 percent in April, its lowest level since May 1991, when the economy was ever so slowly emerging from its last recession. While interest rate reductions will not immediately stoke capital investments, they will increase consumer spending, which accounts for roughly two-thirds of total economic output.
Whether the economy eventually falls into recession will largely be determined by what happens to consumer spending. The negative wealth effect caused by a falling stock market, the deterioration of household finances resulting from an increase in indebtedness, the rising share of consumer spending spurred by skyrocketing energy costs, and an explosion of layoffs have all combined to put significant pressure on consumer spending. Indeed, payrolls fell by 223,000 in April, following a 53,000 decline in March. The unemployment rate has increased by more than half a percentage point since October. These are the factors the Fed must combat with its monetary policy tool.
Global growth has slowed, reducing European, Asian and Latin American demand for U.S. exports. That leaves consumer demand as the only game in town. With inflationary pressures remaining relatively subdued, another one-half percentage-point cut in short-term interest rates seems in order.