Major Business News
Half-Point Rate Cut Shows Fed's Balance Between Reliance on Economy,Markets
By GREG IP and JACOB M. SCHLESINGER
Staff Reporters of THE WALL STREET JOURNAL
WASHINGTON -- For the past five months, Alan Greenspan
has been attempting a delicate balancing act. He has been
striving to show that he is concerned about the economy's
weakness. Yet he has also been trying to demonstrate that
he isn't out to prop up the stock market.
On Wednesday the Federal Reserve chairman unveiled the
latest move in that complex strategy: a surprise
half-percentage point reduction in short-term interest rates.
For weeks, he has taken withering criticism from investors,
commentators and even normally circumspect former Fed
colleagues, who argued that he was behind the curve. Their
attacks rested in part on financial markets that were plunging
on the lack of faster Fed action.
Mr. Greenspan soaked up the censure
and waited until a day when investors
had all but ruled out further rate relief
this month -- and when the stock market
was already rallying. He convened an
8:30 a.m. conference call with his
colleagues and put through the cut, the
Fed's fourth big move this year.
While striving to avoid the appearance of
bailing out financial markets, the Fed
chairman does try to use them to further
his cause, especially by giving out
pleasant surprises from time to time. By
that score, Wednesday's act was a big
success, as markets turned giddy after
the 11 a.m. announcement. The Dow
Jones Industrial Average ended the day
up 399.10 points, or 3.9%, and the
Nasdaq Composite Index rallied 156.22,
or 8.1%.
The action lowered the Fed's target for
the federal-funds interest rate, which
banks use on overnight loans to each
other, to 4.5% -- the lowest level in
seven years, capping a breathtaking
sprint to lower rates. The reduction of
two full percentage points since New
Year's Day is the most the central bank
has implemented in so short a time in 16
years, according to Merrill Lynch. The Fed
on Wednesday also cut its largely
symbolic discount rate by half of a
percentage point to 4%. Major commercial banks followed by
cutting their prime rates to 7.5% from 8%.
Many economists think the Fed still has more work to do,
which the central bank doesn't seem inclined to dispute. Its
statement expressed concerns of continued "risks" of
"economic weakness." The futures market that bets on Fed
action is pricing in a Fed funds rate as low as 4% by July.
Wednesday's move wasn't a response to any sudden
deterioration in the economy. Indeed, the explanatory
statement released with the announcement noted that since
the Fed's last meeting in March, the liquidation of excess
business inventories was "well advanced" and "consumption
and housing expenditures have held up reasonably well." Just
Tuesday, the Fed reported that industrial production
unexpectedly rose in March, following five months of
contraction.
That was also in keeping with the Greenspan tactic of
preferring to avoid the appearance of reacting to any one
specific piece of data. Rather, the Fed is responding to an
accumulation in recent months of still-real threats to
economic recovery: The statement cited weak profits and
business investment, the hit to consumer spending from
shrinking stock wealth, and concern about "slower growth
abroad."
The true depth of the economy's current problems and the
prospects for a swift turnaround hinge in large part on
psychology. If businesses and consumers take heart from the
latest Fed action by spending more, the worst could be over
and the need for further Fed action limited.
Mr. Greenspan's tactics over the past few months reveal
much about how he has carefully attempted to manipulate
the mindset of markets, companies and consumers. He has
been determined to make sure that he is moving markets,
and not the other way around. That is why he has repeatedly
refused to show signs of easing when the market was
plunging and many economists and investors were calling for
it. It's also, however, why he has twice chosen to take
traders by surprise to push through his rate cuts, thus
magnifying the market response.
It was early last fall that Fed officials first began to pick up
hints and complaints that their yearlong campaign to cool the
super-charged U.S. economy with rate hikes may have
succeeded a bit too well. In October, Robert McTeer,
president of the Federal Reserve Bank of Dallas, was a guest
speaker at a board meeting of the National Association of
Manufacturers. Over lunch, the association's president, Jerry
Jasinowski, told Mr. McTeer manufacturers were being hit by
a "perfect storm" of high interest rates, a high dollar and
high energy costs.
Over the next five weeks, other troubling signs emerged,
including falling computer stock prices and rising yields on
junk bonds. When officials gathered for their Nov. 15
monetary policy meeting, they agreed that there was now
solid evidence of an "appreciable slowing in the expansion of
economic activity," according to minutes of the meeting.
Yet there was still no serious discussion of cutting interest
rates soon. After all, this was a slowdown the Fed had
eagerly sought. Some members remained concerned about
tight labor markets, while others were worried that the sharp
rise in oil prices could spark inflation.
Avoiding an Unhealthy Rally
While Wall Street was turning increasingly bearish, Fed
officials at that November meeting were still more worried
about yet another unhealthy rally than they were about a
destabilizing crash.
The Fed has two main policy tools at its
disposal at each meeting. The first is its
target for short-term interest rates. Officials
agreed that no change was warranted at the
November session. The second tool is a
short statement on the Fed's economic
outlook. Over the past two years, Mr.
Greenspan has become increasingly
aggressive about using that to signal
markets where rates will be heading in the
future. Each statement ends with a "bias" --
a declaration that the Fed sees the greatest
risks to the economy tilted toward inflation,
toward recession or evenly balanced between the two.
The economic data discussed at the meeting seemed to
warrant declaring the risks fairly even. But Mr. Greenspan and
others were against dropping the inflation bias the Fed had
maintained for the past few months. Doing so, some officials
feared, would build false hopes for quick rate cuts and spark
a market rebound that would make it harder to keep at or
below the economy's speed limit.
Fed officials were careful not to mention markets in such
explicit terms. But according to their minutes, they expressed
concern that a change in bias could have produced
"undesirable softening in overall financial market conditions,"
which is Fed-speak for rising stock prices, falling bond yields
and easier bank lending standards.
After Thanksgiving, however, Mr. Greenspan started talking
more bearishly about the economy in public. He used a
speech before community bankers on Dec. 5 in New York to
signal the shift in his concerns. Previously, he had lauded
corporate America's tech-spending binge as proof of its faith
in technology's productivity-boosting potential. Now, he
acknowledged, "The current shake-up in some segments of
the telecom and other high-tech sectors" reflected "some
overreaching." He noted the rise in junk bond yields as well
as banks' tightened lending standards and urged bankers not
to go too far in restricting credit from creditworthy
businesses.
Then the bottom fell out.
In the second week of December, Mr. Greenspan and his
colleagues suddenly started getting swamped by calls from
business executives warning them that orders were abruptly
drying up.
One was Lyle Gramley, a former Fed governor who now does
consulting for institutional investors. He had been on the
road shortly after Thanksgiving, briefing clients on the state
of the economy. The message he carried to them was that
the economy was still chugging along at a healthy clip. But
they offered a warning, he recalls: "You're out of date -- the
economy's deteriorating faster than you're talking about." As
soon as Mr. Gramley returned to Washington, he called David
Stockton, the Fed's head of research to pass on the
impression.
Fed researchers worked the phones, conducting their own
confidential up-to-the-minute surveys of sentiment among
businesses around the country, and the news they were
feeding back to Mr. Greenspan was that pessimism was
taking root fast.
On Dec. 13, Mr. Jasinowski and W.R. Timken Jr., CEO of
bearing and steelmaker Timken Co. and chairman of the
National Association of Manufacturers, wrote a letter to Mr.
Greenspan urging the Fed to cut rates ASAP: "Unless action
is taken promptly, we believe that the sharp slowdown in the
economy could lead to an economic contraction and
significant employee layoffs."
By the time the Federal Open Market Committee met again
Dec. 19, members knew it was time to shift gears. But how
much? Some, including Fed Gov. Edward Gramlich, were ready
to cut rates on the spot. But most members were uncertain
economic conditions justified that. Mr. Greenspan also was
opposed, for tactical as well as economic reasons. The Fed,
by shifting its bias all the way from inflation to economic
weakness without pausing at "neutral," would do a lot to
alter market psychology, officials reasoned, and saving the
rate cut for later would enhance the total impact.
Mr. Greenspan is a master at finding compromise between
anti-inflation hawks and New Economy doves, believers eager
to prop up growth. The compromise at that meeting was to
change the bias but, if sentiment didn't pick up soon,
convene before the scheduled late January meeting and cut
rates then. Many officials left the cavernous boardroom that
day convinced they'd all be talking again very soon.
The economic mood didn't pick up
in December. The Fed's informal
surveys of business leaders still
showed deteriorating conditions.
Mr. Greenspan began the last
week of the year with more
gloom. Late on the day after
Christmas, he and then-Treasury
Secretary Lawrence Summers
convened for more than an hour
at the Fed with California Gov.
Gray Davis, who was giving them
a briefing on his state's mounting
electricity crisis. The Fed
chairman also got a private
advance glimpse that week at the
downbeat manufacturing index
from the National Association of Purchasing Management to
be released Jan. 2.
Many officials were expecting Mr. Greenspan to call for a
move the first week of the year but were betting that the
most likely time would be Friday, the day the December
employment report was to be released. One official, slated to
be out of town that day, even made special arrangements
with the local Fed office to be ready to participate in the
meeting by phone.
But Mr. Greenspan chose Wednesday, Jan. 3, instead, in
order to maximize the market surprise. And in a symbolic
move underscoring internally and externally that
once-hesitant officials were united behind the decision, the
Fed chairman called a formal vote on the question. It was a
small gesture, not required by the Fed's by-laws. Officially,
the Fed chairman has the power to act between meetings
without calling a formal roll call.
At first, the rate cut seemed to dramatically dispel the
pessimism then encircling markets and the economy. The
Nasdaq composite rocketed 325 points, a record 14%, while
the Dow Jones average soared almost 300 points. The rally
continued for most of the month. The Fed followed up with
another widely expected half-point cut at its regularly
scheduled Jan. 31 meeting.
But what followed over the next couple of months was an
uncomfortable dance between financial markets and the
central bank. Fed officials parsing the data from the real
economy felt that things weren't actually that bad. The Fed's
internal surveys of business leaders had stabilized. Consumer
spending on houses and cars, in particular, was holding up
remarkably well in spite of falling confidence. Mr. Greenspan
told Congress twice in February that the severe weakness of
late 2000 did not seem to have continued in early 2001.
Mixed Signals
Even some of the business executives who were struggling
didn't show alarm when they met with the Fed. In early
March, Mr. Greenspan appeared before the board of the
Semiconductor Industry Association. Executives were
downbeat, but not as much as might have been expected,
recalls Wim Roelandts, a board member and chief executive
of chip maker Xilinx Inc. "This is our third recession in the
last five years. It is a very cyclical industry. We are maybe
more used to that and less panicked than some other
industries."
But Wall Street was panicking. During February and into early
March, a tidal wave of profit warnings sent stocks plunging to
fresh lows, wiping out the entire post-Jan. 3 rally. And the
worse that stocks performed, the more that markets began to
hope -- and assume -- that the Fed would act to bail them
out. Stock prices, not economic news, became the primary
influence over bets on Fed actions. In late February, the
speculation hit a fever pitch when Bear Stearns chief
economist and former Fed governor Wayne Angell put high
odds that the Fed would cut rates before its next meeting.
When the Fed didn't deliver the intermeeting cut, a new
market feeding frenzy emerged in the days before the March
20 session. While the Fed was clearly ready to make another
half-point cut, calls were growing for an even more dramatic
three-quarter-point reduction, a move unseen since the
depths of the early 1980s recession.
"I was getting a lot of advice before the meeting," from
neighbors and business contacts, Federal Reserve Bank of
Richmond President J. Alfred Broaddus recalled in an
interview earlier this month. Mr. Broaddus was not a voting
member of the Fed's open market committee, but like all
regional presidents is an active participant in all their
meetings. A few days before the meeting, Mr. Broaddus was
riding the elevator down in his office building when another
employee got on. He "didn't say anything until I got down to
the bottom, and when he got off the elevator he looked
around to me and said, 'Do three-quarters,' " Mr. Broaddus
recalls.
Ready to Deliver
Some officials came ready to deliver that, especially with
participants mindful that if they didn't, shaky financial
markets would almost certainly plunge. Yet as Mr. Greenspan
led off the policy discussion that morning from his brown,
padded-leather swivel chair, he told colleagues he favored
the more modest half-point cut. Several others echoed his
points. For one thing, many noted, the data on the real
economy -- as opposed to the stock market -- wasn't so bad
and actually appeared to have steadied.
Besides, officials believed that responding to market
expectations was a dicey game. If the Fed came through with
a three-quarter-point cut that day, investors would be
demanding an even bigger one the next time around. And
there was a real risk that markets would fall even if the Fed
did provide the big cut. Then the central bank's credibility in
battling the recession threat could be more seriously
damaged, some members worried.
Mr. Greenspan and the moderates prevailed in the debate.
When the formal decision was announced about an hour after
the meeting broke up, the stock market, as expected, began
to tumble.
The Nasdaq finished the day down nearly 5%, while the Dow
Jones industrials lost more than 2%. The carnage continued
over the next two days. Between its midday high Tuesday
and the afternoon low Thursday, the Dow dropped more than
900 points, or 9%, at one point falling enough to have
marked the end of its decade-long bull market, though a
late-day bounce intervened.
Waiting for the Impact
Officials insisted that if a three-quarter-point cut had been
justified by economic conditions they would have done it,
regardless of the market. Nor did they ignore the stock
market, which not only conveys a lot of information about the
profit outlook but has real effects on consumers via wealth
and confidence. "You could have made a case" for
three-quarters of a point, Mr. Broaddus says, "But monetary
policy affects the economy with a lag." Consumer spending
seemed to be holding up better than many expected in the
first quarter, he noted. "We had already moved the funds
rate and discount rate down a full percentage point before
that meeting, and we hadn't necessarily seen the full impact
of that."
For Mr. Greenspan, the March meeting was also the latest
stage in a complex attempt to grapple with monetary policy
in an age of outsized financial markets. After his famous
1996 "irrational exuberance" speech and long soul-searching,
Mr. Greenspan decided against pricking the bubble on the
way up. Now, he had ruled out as futile, counterproductive
even, trying to keep it from collapsing on the way down.
Over the next few weeks, Fed officials -- though not Mr.
Greenspan -- hit the road to explain the controversial move.
"Fed policymakers must stand apart from the incessant
demand for instant reaction and the expectation of instant
results," Philadelphia Fed President Anthony Santomero
declared the following week. Atlanta Fed President Jack
Guynn declared in a speech earlier this month, "Monetary
policy is not the tail that wags the bull -- or the bear, for
that matter. Stock prices are ultimately determined by the
fundamentals of the overall economy -- and not the other
way around."
And yet Fed officials have also come to realize that if it they
catch the market by surprise, they can get big market
movements that amplify the impact on financial conditions,
through what insiders call "the announcement effect."
Indeed, some officials actually enhanced the announcement
effect by playing down the prospects of an intermeeting cut.
Speaking to reporters April 10, St. Louis Fed President
William Poole even seemed to rule out an imminent cut.
Acknowledging that "there has been a lot of discussion
about" intermeeting rate cuts, Mr. Poole said "there are
compelling times when quick action is necessary, but this is
not one of them." By earlier this week, markets that bet on
future Fed action had ruled out any cut before the next
meeting, scheduled for May 15.
Then came Wednesday's move.
Write to Greg Ip at greg.ip@wsj.com and Jacob M.
Schlesinger at jacob.schlesinger@wsj.com