Thursday, June 26, 2003

Fed sees firmer economy, trims rates

By John J. Byczkowski
The Cincinnati Enquirer

The Federal Reserve cut its interest rate target Wednesday for the 13th time since January 2001 in an effort to get the U.S. economy moving again.

The quarter-point cut sent the benchmark federal funds rate - the rate banks charge each other on overnight loans - to 1 percent, its lowest level since Dwight Eisenhower was president. The cut was expected, and economists and bankers say interest rate cuts alone won't improve the economy and reduce unemployment.

"It is one more cut in a long series, and it complements a lot of other things going on - oil prices coming down, the end of the war in Iraq, the tax cuts, the lower dollar," said Stuart Hoffman, chief economist for PNC Financial Services Group Inc. in Pittsburgh. "These are all things that hopefully, collectively, will contribute to an improved economy and an improving job market."

The interest rate cut is almost meaningless to factories that are operating at about 75 percent of capacity.

"They can burn through a lot of capacity before they need to borrow for equipment and for buildings," said Andy Hawking, executive vice president for middle-market lending at U.S. Bank in Cincinnati.

"What the economy needs is a demand spurt. That is ultimately created by the consumer, from having jobs and having confidence that the economy will turn around."

To that end, the cut should put more dollars in many borrowers' pockets.

The Fed's action almost always leads to a cut in banks' prime rate, which influences rates on auto loans, credit cards and other consumer credit.

Mortgage rates, however, have fallen the past several weeks in anticipation of the cut, so the Fed's action doesn't directly affect them.

In announcing the interest rate cut, the Fed said it finds the economy no longer deteriorating. "Recent signs point to a firming in spending, markedly improved financial conditions, and labor and product markets that are stabilizing," the Fed's statement said.

But the economy hasn't shown signs of sustainable growth. A quarter-point cut "would add further support for an economy which (the Fed) expects to improve over time," the statement said. The Fed also said it still sees a continued risk of deflation, indicating that it won't raise interest rates anytime soon.

The vote by the Fed's policy-setting Open Market Committee was 11-1 in favor of the quarter-point cut, with one Fed governor - Robert Parry, president of the Federal Reserve Bank of San Francisco - voting in favor of a larger, half-point cut.

The committee also cut the discount rate - which the Fed charges on loans to banks - by a quarter-point to 2.0 percent.

Many observers had expected a half-point cut in rates, and that disappointment contributed to a drop in the stock markets. The Dow Jones Industrial Average fell 98.32, or about 1.1 percent, to 9011.53.

"I'm surprised they didn't move (a half-point)," said Gregory Hess, an economist at Claremont McKenna College in California. He said the Fed has closely studied the situation in Japan, where 10 years of economic stagnation and deflation has been blamed in part on a lack of aggressive action by that country's central bank.

Cutting rates a quarter-point instead of a half-point reflects "more of a slow-and-steady approach, which is not the lesson I would have thought they would have learned from Japan," Hess said.

In the meantime, local bankers say businesses continue to put off plans for expansion and hiring, waiting for the economy to improve. John Taylor, president of PNC's Ohio-Northern Kentucky region, said businesses are taking advantage of low interest rates to get their financial houses in shape.

There's little borrowing, however, for new plants and equipment. The most optimistic businesses see growth improving in late fall, he said, but many don't expect improvement until 2004.

Chris Carey, chief financial officer at Provident Financial Group Inc. in Cincinnati, agreed.

"Everybody's very cautious. I don't think you have a lot of people talking about a lot of expansion plans," he said.

"On average, we describe business as somewhat stable - not a lot of growth, but it doesn't seem to be shrinking anymore."

Winners and losers

Winners: Anybody with debt tied to the prime rate. Banks are likely to cut the prime to 4.0 percent from 4.25 percent, so those credit costs will fall.

Losers: Savers. Interest rates on savings are already low, and the Fed signaled that it's not likely to raise interest rates soon.

Mortgage borrowers. Mortgage rates had already built in the Fed cut, so they're not likely to fall further. Homeowners refinancing their mortgages are already inundating lenders.

Excerpts from the Fed's statement

"The (Federal Open Market) Committee continues to believe that an accommodative stance of monetary policy, coupled with still robust underlying growth in productivity, is providing important ongoing support to economic activity. Recent signs point to a firming in spending, markedly improved financial conditions, and labor and product markets that are stabilizing. The economy, nonetheless, has yet to exhibit sustainable growth. ...

"The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome substantial fall in inflation exceeds that of a pickup in inflation from its already low level. On balance, the Committee believes that the latter concern is likely to predominate for the foreseeable future."


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