When the U.S. Federal Reserve Board started cutting interest rates, there was a lot of talk about how investors shouldn't "fight the Fed" because the market would inevitably rebound after a series of cuts. When those rebounds that did occur were just as quickly erased, some investors no doubt began to wonder -- but then the soothing refrain was that it always takes six months for rate cuts to work their way into the overall economy. So here we are. We've taken our medicine, how come we're not getting any better?
The answer -- as usual with things economic -- depends on whom you ask. Fed chairman Alan Greenspan, the market's favourite mechanic, believes he has the tools required to do the job and that investors and economy watchers should just be patient. In the second part of his regular testimony before the U.S. Senate banking committee, Mr. Greenspan was asked about why the unprecedented series of rate cuts have so far had little effect when it comes to boosting either the economy or the stock market.
In effect, the Fed chairman said investors need to have faith in the central bank. Looking at some of the troubling factors economists have mentioned -- such as the fact that long-term rates are still high, and the U.S. dollar is still strong -- ignores "all of the various different channels" through which the Fed's lever-pulling affects the economy, Mr. Greenspan said. "You essentially get very complex differences in the way monetary policy plays out, but at the end of the day, it does seem to be effective." In other words, it's hard to explain, but don't worry -- it still works.
If you believe that Mr. Greenspan is a cross between the Oracle of Delphi and the Wizard of Oz, then his response will probably make you feel a lot better. But what if the Fed chairman -- like a lot of mechanics and engineers -- happens to have a box full of hammers, and therefore sees everything as a nail? Or what if he is loosening the screws as fast as he can, but they aren't attached to what's actually broken? Then you have a different kind of problem, especially if you don't know any other mechanics.
One of the biggest issues for the Fed is that short-term interest rates -- the kind that Mr. Greenspan influences -- are not really the problem. Low rates are probably helping convince consumers to buy houses and cars, but that's not where the major weaknesses are in the U.S. economy. The weakest parts are the manufacturing sector and tech, neither of which benefits from lower short-term rates. Even if rates were zero, it wouldn't help the inventory glut in the telecom and computer sectors, because no one in their right mind wants to borrow money to buy any of those products.
Manufacturing also doesn't benefit from low short-term rates -- it needs lower long-term rates, and yet they remain stubbornly high. Why? Ironically, it's partly because investors are assuming the omnipotent Mr. Greenspan will triumph and the economy will recover next year, and they are already pricing that assumption (and the fear that inflation will result) into long-term bond prices. By doing so, of course, they can actually help to delay the recovery that everyone is so desperately hoping for.
A similar kind of vicious circle is playing itself out on the international scene, as foreign investors whose own economies are either weak or weakening plow their money into the U.S. greenback -- keeping it higher than it might otherwise be. The U.S. economy may look to be in rough shape at the moment, but it is still seen by many as the best port in a storm. Unfortunately for Mr. Greenspan, a strong U.S. dollar actually hurts the manufacturing and export sectors of the U.S. economy, and thereby also delays the recovery those foreign investors themselves are counting on.
According to a recent report in The Wall Street Journal, China alone bought nearly $30-billion (U.S.) in dollar-denominated securities in the year ended in April -- more than all of the commercial banks in the United States put together and three times as much as the country's insurance companies, traditional buyers of the dollar securities issued by mortgage agencies Fannie Mae (the Federal National Mortgage Association, or FNMA) and Freddie Mac (the Federal Home Loan Mortgage Corp., or FMC). European and Asian countries have also been buying as many dollars as they can.
Members of the European Union are somewhat irritated by the strength of the U.S. buck, because the capital flowing into that currency means less investment in the euro, which continues to sag. But U.S. Treasury Secretary Paul O'Neill has made it clear that he isn't interested in doing anything to try to lower the dollar -- a strong dollar, he said, is a natural result of a strong economy. Currency experts say even the suggestion that the government is interested in weakening the greenback might start a run on the dollar, which certainly wouldn't do the U.S. economy any good.
So what does Mr. Greenspan do? There may be nothing he can do, at least not now. The inventory problems that the telecom and computer sectors are going through will not be solved by interest rates or a looser hand on the money supply tap, but by time and a resumption of demand. And consumers can buy all the houses and cars they want, but that's not going to help the manufacturing sector overcome the impact of higher rates and a strong dollar. Demand worldwide has to pick up first, and pick up substantially -- and not even Mr. Greenspan can make that happen, no matter what levers he pulls behind that little curtain of his. Mathew Ingram writes analysis and commentary for globeandmail.com mingram@globeandmail.ca