Interest Rates Might Come Down Again

This is going to be an interesting week. Americans go to the polls today. The outcome of the election will determine whether the president will gain control of the Senate and retain control of the House, in which case he will push through tax reforms that are being suggested to him by his economic team. President George Bush’s men want to end what they see as double taxation of corporate profits by eliminating taxes on dividends, making permanent the tax cuts now due to expire in 2011, increasing the amount of losses that investors may deduct from their tax bills (the current limit is $3,000), and introducing a variety of measures to encourage savings and private provision for health care and retirement. None of these measures appeal much to Democrats, who see them as favoring high earners.

Of more immediate consequence to the economy will be still another decision due this week. Federal Reserve Board chairman Alan Greenspan is an avid weekend tennis player, and knows that the old saw, “the ball is in your court,” applies not only to his activities on the court. On Wednesday he and his monetary policy committee must decide whether a further cut in interest rates is required to prevent the dreaded three Ds: double dip and deflation.

Many analysts think that the reported collapse in consumer confidence makes the decision an easy one. Rates should come down, they say. After all, last week’s Conference Board survey showed that the index of consumer confidence fell by 14 points, to the lowest level in nine years. That is the largest one-month drop since 1990, except for the plunge immediately after the September 11 terror attack. Surely that means that the American consumer, whose spending has offset the collapse in business investment and kept the economy growing, is about to take a holiday from the shops, car showrooms, and even the market for ever-larger homes—with dire consequences for the economy and for share prices.

To which any informed observer should reply with a resounding and confident, “perhaps.” Ed Hyman, an analyst with the ISI consulting group, points out that the consumer confidence index fell even more in September of 2001, by some 17 points. It then dropped another 12 points in October. Yet the economy grew by almost 3 percent in the fourth quarter of 2001.

Share prices also failed to respond significantly to the decline in confidence. On October 30, after the confidence index had registered a two-month decline of 29 points, the Standard&Poor’s index of 500 stocks dropped 20 points, remained unchanged the next day, and then rose by 25 points. The question is less what consumers say than what they do, often a different thing. Glenn Hubbard, chairman of the president’s council of economic advisers, agrees. He told the press, “Economists will be watching what consumers do, more than what they say.”

Consumer-watching is more art than science. Chain store sales are reported to be running at their lowest level since January, but Wal-Mart says it is on target to meet its sales forecasts. The hot automobile market cooled off in recent weeks, and only 6.8 percent of respondents to the Conference Board survey say they plan to buy a car in the next six months, the lowest in more than a year. But industry executives say they can’t determine whether this is merely a temporary phenomenon, or a scary sign that consumers have bought all of the vehicles that zero-interest financing can induce.

Which brings us back to Greenspan and the Fed. The force that has kept the economy moving has been the housing market. The Fed’s low interest rates have made houses affordable to first-time home buyers, many of them immigrants, and to richer folks who have been trading up. These low rates have also enabled owners to “mortgage out,” refinancing their mortgages to extract equity from their homes for use in the malls and shops of America.

But now only 3.1 percent of consumers say they plan to buy a new home in the next six months, the lowest figure in two years. If they do what they say, consumers will be reversing the summer’s record sales of new homes, a spurt that led to a 13.3 percent jump in new housing starts in September. That, guess economists at Goldman Sachs, “is probably close to [the] high water mark” in housing activity.

Unless, of course, incomes continue to rise and the Fed gives the market a boost by making it still cheaper to buy a home—and the furniture, carpets, and appliances that go along with it. Greenspan knows that once deflation starts it is difficult to reverse. But he knows, too, that housing is the most interest-rate sensitive sector of the economy, and that lower rates might turn a boom into a bubble. Neither deflation nor a housing bust is very likely, but the Fed chairman can’t discount these opposite dangers completely.

He also must figure out just what data released late last week really mean. The economy grew at the quite satisfactory annual rate of 3.1 percent in the third quarter, a jump from the 1.3 percent second-quarter rate. But take out booming car sales, which are now slowing, and the growth rate drops to a mere 1.5 percent. The unemployment rate edged up an inconsequential 0.1 percent, to 5.7 percent, but that is still historically low, and on the plus side average hourly earnings rose a bit.

Faced with these uncertainties, Greenspan might well choose the most easily reversed error. If he keeps rates up and deflation sets in, it will be difficult to reverse. But if he lowers interest rates, and the economic recovery proves too hot for the comfort of anti-inflation hawks, he can jack rates up and cool the economy down. When it comes to rate cuts, too much, too soon, is probably better than too little, too late.

This article appeared in London’s Sunday Times on November 3, 2002, and is reprinted with permission.