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The feeble Fed
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October 1, 2001: 8:21 p.m. ET
Fed chairman Alan Greenspan keeps cutting rates. Why isn't it doing any good?
By Michael Sivy
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NEW YORK (Money) - Fed Chairman Alan Greenspan cut interest rates again Tuesday – the ninth reduction this year in the rate banks pay for borrowing money overnight. At 2.5 percent, the fed funds rate is now at its lowest level since 1962.
This string of cuts has been one of the fastest reductions in rates since the Fed was founded in 1913. And it ought to be fueling an economic rebound -- but it isn't.
After four quarters of slowly deteriorating performance, the economy slipped into recession following the Sept. 11th terrorist attacks, and economists now project that inflation-adjusted gross domestic product will decline at nearly a 1 percent annual rate in the second half of the year.
What gives?
Why aren't the rate cuts working? Has the Fed lost its moxie? Or is the current economic decline unstoppable?
In fact, the outlook isn't nearly as bad as the pessimists think. Just consider the two previous cases when central bank rate cuts failed to reignite a stalled economy -- the Great Depression and the decade-long recession in Japan that still hasn't ended.
The Great Depression was the result of a banking-system collapse. If banks are closing, it doesn't matter if the Fed cuts interest rates because there isn't anybody around to lend the money to businesses and consumers.
But the current problems of U.S. banks are nowhere near that severe. In the late 1990s, they did lend too much to telecom firms and dotcoms -- and also to consumers with too many credit cards. The resulting bad loans will discourage banks from lending expansively for a while, but they certainly don't threaten the banking system.
The situation in Japan is even less of a parallel. The Bank of Japan cut interest rates close to zero but failed to revive that economy. The problem was that Japan remained committed to propping up troubled companies and protecting jobs at almost any cost. By contrast, companies in the U.S. try to get their layoffs and cutbacks over with as quickly as possible. It's just like with a bandage -- trying to remove it really slowly takes longer and hurts more than if you just go ahead and yank it off.
Help is on the way
The problems in the U.S. economy should all be resolved by the passage of time. They'll also be greatly helped by the enormous monetary and fiscal stimulus that's on the way. The Fed's lower rates continue to spur mortgage refinancing. And every time a household refinances, it has an average of $150 a month extra to spend. The tax cut will give households a little extra on top of that.
In addition, the government has already earmarked $40 billion for security and rebuilding after Sept. 11th. Incremental defense spending could be equally large. And further appropriations will almost certainly bring the total to well over $100 billion by next year.
The recovery has been delayed. The Fed may have to take rates down lower than Greenspan would like. And the government may have to spend more than budget-balancers would like. But with enough gas, the economy will eventually roar to life.
If there's any hidden risk in all of this, it's that inflation will again become a problem several years from now. When there's a growing amount of money in circulation, some of it goes to bid up the prices of financial assets such as stocks. A little of that would be quite a relief to shareholders. But excess liquidity can also bid up the prices of goods and services, creating a significant amount of inflation.
The chief requirement for portfolio management right now is patience. There are more hurdles to jump than in most cycles, but the course is the same. Growth stocks, including tech, should provide the greatest returns when the recovery finally arrives. And finally, this is a really good time to make sure than your portfolio includes some inflation protection -- including energy stocks, metals and mining shares, and real estate investment trusts. 
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