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www.ecommerce-guide.com/news/news/article.php/557331
By Don Sussis January 10, 2001 In a move that was considered overdue by some and bold by many, on January 3rd, Federal Reserve Chairman Alan Greenspan cut the federal funds target rate--the rate that banks charge each other for overnight loans--a fat half point to 6%. The move follows six rate hikes that began in June 1999. It is the first cut since November 1998. The move was all the more remarkable because it came two weeks before the next scheduled meeting of the Federal Open Market Committee (FOMC), the Fed''s policy-making arm. The last time the Fed changed rates between meetings was a quarter point cut in October 1998 when the Central Bank was moving to counter the global havoc caused by the Asian economic crisis. The FOMC consists of Chairman Greenspan and five of the 12 presidents of the 12 Federal Reserve banks. Their next scheduled meeting is January 30-31, 2001. As Chairman, Mr. Greenspan has the authority to raise or lower rates on his own between meetings without a vote. In this case he held a conference call that included all members of the committee in the morning to discuss a change in rates immediately. The call began at 11:00a.m. and lasted about an hour. During this time Chairman Greenspan asked for a formal vote from the committee rather than acting on his own. The agreement for the cut among members has sounded the alarm that the economy is in some danger--something the equity and bond markets have been signaling for months. The markets reacted immediately. Within 30 minutes of the Fed''s rate cut announcement, the Nasdaq composite index had recouped 12% of the 55% it has lost since its peak in March 2000. By the closing bell, it had soared a record 14.2% -- its biggest one-day climb since the market was established 30 years ago. Trading volume on Wednesday was heavy with over two billion shares traded on the New York Stock Exchange (NYSE) and over three billion shares changing hands on the Nasdaq -- both records. Advancing shares beat declines by 22-7 margin on the NYSE and 13 to six on the Nasdaq, as stocks advanced across the board. The Fed also cut its discount rate by a quarter of a point to 5.75 %. The reason for the smaller cut is that member banks must request a specific rate reduction before it can be granted. Apparently, none of the banks thought to request such a cut because the Fed specifically stated in its announcement that they were ready to lower the discount rate another 25 basis points (a quarter point) if they were asked. Indeed, all 12 Federal Reserve banks made the request almost immediately and the rate was cut to 5.5% the next day (Thursday). Changes in the discount rate are made by the Board of Governors. The discount rate is often considered symbolic (especially in good times) because it follows the more important Federal Funds Rate. However, in times of economic stress, the discount rate increases in importance because it eases the reserve requirements of banks, thus adding liquidity into the system. These unusual moves by the Fed highlight problems in the economy. The statement announcing the move said: "These actions were taken in light of further weakening of sales and production, and in the context of lower consumer confidence, tight conditions in some segments of financial markets, and high energy prices sapping household and business purchasing power." The Fed statement went on to say "The committee continues to believe... [considering] the information currently available, the risks are weighted mainly towards conditions that may generate economic weakness in the foreseeable future." The aggressiveness and the timing of the rate cuts by the Fed came amid growing concern that the U.S. economy is slipping into a recession-if, in fact, it is not already in one. Economists generally wait for data to confirm that a recession has taken place, but that information can only be had after the fact. This is because a recession is defined as two consecutive quarters of negative growth in GDP and that data is always lagging real economic performance. The stock markets are often a better predictor because they function as a discounting mechanism that anticipates compiled economic data. Why did Chairman Greenspan lower rates between FOMC meetings? There is speculation that the incoming data on the economy was decisively negative. For example, the day before the rate cuts were made, The National Association of Purchasing Management (NAPM) index report made clear that manufacturing activity is at the lowest levels in a decade. It has fallen to the lowest levels since the recession of 1990-1991. The index stood at 43.7 down from 47.7 in November 2000. It was the fifth straight month the index was below the break-even level of 50 and near a reading of 42.4 that indicates a recession. The report is based on data from purchasing executives at more that 350 companies that buy raw materials and supplies for manufacturing. Of the 20 industries in the report only printing and publishing reported better business in December than the prior month. For example, the backlog of orders index fell for eight straight months, a sign of weak demand. Another sign of trouble is the weakening credit markets. A day before the Fed move, Standard & Poor''s Corp. (S&P) announced that its industrial-grade credit index had widened three basis points vs. Treasuries at the end of December. This indicates that investors were more attracted to risk-free Treasuries than to corporate bonds. The result is less liquidity for business borrowing, making expansion difficult -- a sign of a souring economy. Still another factor may be the possible default of California''s two largest power companies, California Edison and the Pacific Gas & Electric Company, and the pressure that their bankruptcy would put on banks and other financial institutions. (The two electric utilities may be only weeks away from bankruptcy.) That is what major credit rating agencies like Fitch, Moody''s, and S&P are implying as they continue to downgrade the debt of the two utilities. The fact that energy costs are skyrocketing has also dampened consumer spending and drained money from the economy. All of these factors influenced the Fed''s aggressive decision to cut rates now. Don Sussis is an eBusiness Consultant and Investment Advisor in Manhattan. He is the E-Consultant columnist and writes about economics, technology and enterprise. He can be contacted at dsussis@internet.com. |
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