When the US Federal Reserve cut overnight interest rates by half a percent to 5.0%, the US stock market showed its disappointment by dropping another couple of points; investors were certainly not impressed. It is unfortunate that everyone and his dog has seen it fit to lambaste the Fed for its conservatism. It is especially saddening to see a renowned economist such as Paul Krugman jump on the bash-the-Fed bandwagon.
Barely three days after the Fed announced it cuts, and the stock market took a further tumble, Mr. Krugman was on the horn to the New York Times with an article detailing the failure of the Fed in it’s latest round of cuts. By “pulling it’s punches”, he wrote, the Fed’s initiatives were almost “certain to fail”. But by the looks of the American stock market, and by extension, the general American economy, even a metaphorical Mohamed Ali would not have been able to do anything to turn things around in such a short period of time.
Where art thou Ali?
Let’s look at some of the facts: major players in the American economy had been failing all over themselves this financial quarter. For the first time in its history, Cisco laid off 9,000 workers on the 9th of March – a sure signal that a significant profit warning is soon to follow. Intel, the blue-chip of blue-chips among the American tech stocks has been faltering in recent weeks, some of it because of increased competition from rival chipmakers, AMD and some of it because overall demand for microprocessors has dropped over the past few months to an all time low. Motorola has reported it’s first quarterly loss in over 16 years, a reason behind it’s recent dismissal of 7,000 of it’s workers. Oracle and Sun have also pitched in their own doses of financial bad news. Just a short look over at how the NASDAQ has performed these past few months is very telling: from a 250+ CI in the fourth quarter of 1999 to 100 in the first quarter of 2001. By such figures, the market has lost more than 50% of its value and under no terms whatsoever can this be a good sign for the American economy.
Ouch!
With more Americans than ever in history owning some stock, in one form or the other, the capital investment that even the average Joe has placed in the economy will surely bring terrible pain to him under current conditions – seeing the value of your stock portfolio vanish into thin air cannot be a pleasing sight. Naturally, with things so bad, people are beginning to save, not spend as much and this will certainly spell trouble for those who depend on consumer dollars to meet profit projections. The psychology of the average person is simple: save when times are bad and spend when you have extra.
Could the Fed have changed this mentality?
Contrary to what Mr. Krugman and others believe, the simple answer to that is, no. The problem with the American economy nowadays is that people have begun to equate the national economy with the stock market. The Dow, the NASDAQ, the S&P – no matter how tempting it might be to assume otherwise (it’s easier on the gray matter to do so), it isn’t the economy. All that the stock market is, at its very fundamental core, is a reflection of how confident investors are in the state of the national economy. When this happens, the stock market tends to be extremely irrational, subject to the various winds that constantly pass its players. In the case of the US stock markets, a vicious downward spiral began to appear: as the stock market losses more and more of its value, people begin to sell more and more in an attempt to cut their loses. This leads to a further stock market tumble, thus leading to another round of selling, etc. End result = very bad situation.
Economy = rational. Stock market = irrational.
The Fed’s decision for modest cuts was extremely rational, and long-sighted. To a degree, it was caught between a rock and a hard place: it had to do something to return (irrational) investor confidence and at the same time not be seen to be bailing out the fools who had bought the farm in the stock market through a combination of bad luck and sheer stupidity. At the same time, the Fed allowed itself some leeway by keeping the door open for further cuts, if and when needed in the future. Overall, the small cut was a very good decision, one which will certainly have positive long-term ramifications.
The Japanese lesson
What most people seem to miss is that the central bank of any country exists to regulate the good times, and to help out where it can when times are bad. It certainly is no panacea; when times are bad, often there is very little any central regulatory body can do about it. Just take a look at the Japanese central bank where it has cut interest rates to virtually zero. The Japanese economy is still in a mess; it has been that way for some time now, and even with zero interest rates, it looks like it’s going to stay that way for some time to come for the simple reason that fundamental weaknesses exists at the core of the Japanese economy.
Although the US does not suffer from similar weaknesses, it is going through the down-phase of a normal economic cycle – admittedly, this phase is entering a slightly prolonged state but one may argue that this is not because the stock market has loss so much value over the past few months but because most of it’s value so far has been illusory and the necessary corrections are simply being made now. There was nothing the Fed could have done to stop this from happening. Even if it could, would it not have only served to prolong the illusion?
Appearing on www.renungan.com 24 March 2001
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