On Wednesday afternoon, the U.S. Federal Reserve Board crossed into territory the United States hasn't seen since the late 1950s -- when Dwight Eisenhower was president, Leave It To Beaver had just premiered, hula hoops were hot and the U.S. launched its first space satellite. The central bank cut its federal funds rate by a quarter of a point to 1 per cent, lower than it has been since 1958. Not that long ago, the Fed was on guard against inflation; now, it is trying to produce as much inflation as it can.
The choice the Fed was confronted with on Wednesday was whether to cut rates by a quarter or a half a point. Those who argued for a half point -- and there were many, including Merrill Lynch economist David Rosenberg -- said such a cut would send a message to the markets that the central bank was serious about fighting deflation and getting the U.S. economy on the move again. That perception in itself would be beneficial for the markets, the theory went, which would also help improve confidence.
Federal Reserve chairman Alan Greenspan himself seemed to be leaning toward a larger move, since he told the U.S. Congress last month that he and the rest of the central bank governors were worried about deflation -- or "an unwelcome substantial fall in inflation," as he put it -- and were prepared to take action to prevent it from occurring. Many market watchers assumed that the Fed would want to take out some "insurance" against that prospect by cutting its benchmark lending rate by a larger amount.
"The Fed wants to generate a boom and it wants to generate inflation. So which of the two choices -- 25 or 50 [basis points] -- is more consistent with that?" Mr. Rosenberg asked in a research note just before the Fed decision. The answer, he suggested, was the larger cut. The prospect of a bigger cut seemed even more likely because Mr. Greenspan had said in his testimony that the risks of a large cut were relatively few, since inflation is so low that the chance of a cut causing an unwelcome rise in prices is remote.
Other analysts, however, recommended that the Federal Reserve cut by a quarter point. Some argued the United States is beginning to grow stronger, and therefore the economy didn't need a half-point cut in rates, while others said that a quarter-point cut would leave the Fed a little breathing room, and allow it to produce a further rate cut later this year if the economy still refuses to budge. Some also thought that cutting by half a point might send markets a signal that the economy was even worse than expected.
The Fed's carefully worded policy statement left room for further cuts if necessary. While the central bank's open market committee said that the "the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal," it added that the probability of an "unwelcome substantial fall in inflation" outweighs that of a pickup in inflation. This latter risk, it said, "is likely to predominate for the foreseeable future." In other words, the Fed is still on the lookout for deflation.
One of the problems with the quarter-point cut, however (which BMO Nesbitt Burns economist Sherry Cooper called "wishy-washy") is that it may not be enough to accomplish the Fed's goal of bringing down long-term interest rates and stimulating the economy by increasing liquidity. In the wake of the announcement, for example, the yield on longer-term bonds rose -- which is the exact opposite of what the Fed wants to see, since interest rates on all sorts of debt, including mortgages, are tied to long bonds.
"The Fed has again tried to be all things to everyone and ended up being nothing to nobody," Drew Matus of Lehman Brothers told Reuters, as the Dow Jones average sold off by almost 100 points. "They've certainly disappointed the half of the Treasury market that was looking for a 50 basis point cut." Some market analysts said that stock prices fell because investors were hoping that a much larger cut would stimulate demand.
And what were things like in 1958, the last time the bank rate was at 1 per cent? Alan Greenspan was 32 years old. He was part of a circle of admirers of influential philosopher Ayn Rand, whose school of libertarian thought was known as Objectivism, and he often spoke at her seminars. In 1954, Mr. Greenspan put his economics PhD on hold and formed a consulting firm with a friend, taking over the company when his partner died in 1958. In 1968 he was hired as an adviser to future president Richard Nixon.
In the 1950s, the U.S. economy was in the early stages of an economic boom that would last through the 1960s and into the 1970s, fuelled by a post-war industrial expansion, cheap energy costs and an increase in consumption as a result of the "baby boom." Now, the U.S. economy looks a lot different, with high unemployment and low demand across a range of sectors, the lingering after-effects of the 1990s tech bubble.
Can lower rates give the U.S. economy the push it needs to start growing again? As one analyst told CNBC, if the Fed had a patron saint they likely be praying to him or her right now.
E-mail Mathew Ingram at mingram@globeandmail.ca
Mathew Ingram's past columns and a short biography are here
Look for exclusive Mathew Ingram commentary at GlobeInvestorGold
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