Greenspan’s Unsurprising Move

At some point in the last couple of weeks, it became a foregone conclusion that the Federal Reserve’s Open Market Committee would announce an interest-rate cut this afternoon. In fact, it became such a foregone conclusion that investors began speculating about–and in some cases anticipating–that the rate cut would not be a mere quarter-point cut, but rather a half-point cut. Hopes of that probably contributed to a run-up in stock prices yesterday, and to a more generally bullish tone on the Street in the past week.

Those hopes were, of course, dashed at 2:15 p.m., when the FOMC announced that, as expected, it would be trimming the Fed Funds rate by a quarter point. The Dow, which had been up slightly just prior to the announcement, immediately dropped by more than a hundred points, followed by the other major indices, and although it recovered much of that in the next hour, it still finished the day in negative territory. The last few days, then, have been an excellent study in the market’s tendency to overreact in every direction.

Hopes for the half-point cut were essentially idle ones, since Greenspan’s reputation for caution is well-deserved and since the Fed remains populated by inflation hawks, even in these deflationary times. More to the point, there was an unhealthy undertone to much of the pleading for a larger rate cut. This undertone suggested that the Fed would be well-served to give U.S. stock prices a boost in these turbulent times, and that a half-point cut would send the signal that the bull could resume its run. Needless to say, Greenspan has no interest in propping up still historically-high stock valuations, and the dreams of a rate-cut rally smacked of the lamest sort of pie-in-the-sky thinking.

It may very well be true that the Fed will continue to cut rates over the next few months, in an attempt both to keep the U.S. expansion on course and to lessen the pressure on weak foreign currencies. Certainly the fact that the 30-year bond yield remains below the overnight rate (that is, it costs more to borrow money for one night than for 30 years) suggests that further rate cuts are in the offing. But the fact that Tuesday’s rate cut didn’t meet the Street’s expectations shouldn’t obscure just how remarkable the transformation in the Fed’s attitude has been.

After all, the U.S. unemployment rate is still below 4.5 percent. Economic growth has slowed, but is still solid. Consumer confidence and consumer spending remain high. Corporate profits do seem to be entering a recession, but an important chunk of that decline comes from abroad, and in any case the economy can grow healthily even while profit growth is slow. Given these conditions, the old Fed would undoubtedly have viewed any rate cut as just begging for inflation and for an unnecessary expansion of credit. But the new Fed recognizes the dangers of deflation, and is also convinced that the collapse of emerging-market economies and the slow descent of Japan will have serious consequences for the United States. What’s astonishing is how rapid the change of opinion has been.

From one angle, in fact, if the Fed had instituted a half-point cut (or if it had cut the discount rate instead of the Fed Funds rate), investors would have a better reason to sell than with the quarter-point cut. A half-point cut, after all, would have been a sign that the Fed thought real trouble was just around the corner, and that only a flood of credit into the economy could save it from recession. What the quarter-point cut sends instead is the message that we’ve grown accustomed to Greenspan sending: Things are dicier than they’ve been, but the United States is still in good shape. It’s a message you can disagree with, but it’s not a message anyone should have been surprised to hear.