Why Fed Critics Are Demanding Big Rate Cuts

The Federal Reserve should stop messing around with piddling interest rate cuts, and slash the heck out of them--to levels below the inflation rate--if there’s to be any hope for the economy.

That’s the message from a rising chorus of Fed critics in the wake of Friday’s devastating August employment report.

The economy lost another 83,000 jobs in August, far more than most experts had anticipated. The Federal Reserve appeared stunned by the news as well: The Fed on Friday quickly engineered a quarter-point cut in the so-called federal funds rate, which is what banks charge each other for overnight loans.

But therein lies the problem, say the Fed’s critics: The Fed has nickel-and-dimed us to death with small interest rate cuts since mid-1990--when it should have made a few big, bold cuts at key junctures to zap the economy to life.

“It’s amazing that anybody could make the same mistake over and over again,” says an angry Robert Brusca, economist at Nikko Securities in New York.

Lacy Hunt, economist at CM&M; Group in New York, agrees. “A new approach is required,” he says. “The old game plan has failed.”

These economists and others argue that the Fed should push short-term interest rates dramatically lower in a hurry, slicing three-month Treasury bill yields from 2.98% now to 2%, 1.5%, or even less. The target for short rates in general should be well below the current annual inflation rate of 2.7%.

If that sounds crazy, look at history: In most prior recessions, the Fed has been forced to cut short-term rates below the prevailing rate of inflation before economic growth began to pick up.

In other words, the price of money had to get so cheap that lenders were actually accepting negative returns to get borrowers to take their funds:

* In 1970, for example, the recession of that year ended when three-month T-bill rates slid under 5%, while inflation for that year ran at 5.7%, as measured by the Consumer Price Index.

* In 1975, the horrendous recession begun in 1974 ended with three-month T-bills around 5.5%, while inflation ran at 9.1%.

Admittedly, some economists aren’t sure that negative (below-inflation) short-term rates are absolutely necessary for a recovery to begin. “I don’t know if the cause and effect is really there,” says Salomon Bros. economist Robert Di Clemente, noting that the economy rejuvenated in 1982 without negative real rates.

Nonetheless, he agrees that the Fed’s rate-shaving tactics to date have failed miserably. For older Americans with bank CDs, repeated small cuts in short-term rates since mid-1990 have been like Chinese water torture, Di Clemente notes: People keep assuming each little cut is the last, so many stay put in short-term CDs rather than move to longer-term investments.

At the same time, long-term interest rates, such as on car loans and mortgages, have remained high, inching downward only a little with each Fed cut in short-term rates.

The result, Di Clemente says, is that “many Americans now sense a great distortion between what they’re earning on their investments and what lending institutions force them to pay.”

That distortion is even more painful in reality than it appears on paper, Nikko’s Brusca says, because the federal government no longer allows consumers a tax deduction for interest payments on loans other than home mortgages.

Adjusted for inflation, the real annualized cost of a car loan to consumers in the median tax bracket is 7.3% today, Brusca says.

In contrast, the real cost of that kind of loan to the same taxpayer in 1974 was a mere 0.8%, he says--because interest was deductible, and the deduction was worth more because tax rates were higher.

Is it any wonder that people were more willing to buy cars coming out of the 1974 recession than they are today?

The only solution, Brusca says, is to pull long-term interest rates down meaningfully and quickly.

Hold on, though. Most investors know there are a host of reasons why long-term rates have remained high--among them, deep-seated inflation worries, the massive federal budget deficit and high overseas rates.

What’s more, it’s clear that many Americans simply don’t want to borrow, no matter what the interest rate. They’re more concerned about saving and investing, which in the long run is what the economy truly needs.

So isn’t it possible that even a major Fed rate cut on the short side wouldn’t translate into deep declines in long rates? Or that, even with lower long rates, people still wouldn’t rush to spend money?

Maybe, say the Fed’s detractors. But they contend that the risk of economic harm from “shock-treatment” rate cuts is less than the risk of maintaining the Fed’s present tortoise-like rate approach. The latter only worsens the economy’s overriding problem, which is the pervasive loss of faith by consumers and businesses, Fed critics say.

“This is not the 1930s, but it is a quasi-1930s situation,” says CM&M; Group’s Hunt, referring to the Depression. “The Fed hasn’t understood the depths of the economic problem.”

Are Interest Rates Still Too High?

While the Federal Reserve cut interest rates again Friday, some experts argue that the only way to get people borrowing again-and the ecomony moving-is to slash short-term rates to a level well under the inflation rate. That would finally bring long-term rates down to attractive levels, the Fed’s critics say. Where rates stand on different loans and investments:

Average credit card rate: 17.54% Average new car loan rate: 9.61% 30-year mortgage rate: 7.94% 30-year Treasury bond yield: 7.29% Prime lending rate: 6.00% 7-year Treasury note yield: 5.87% 1-year Treasury bill yield: 3.17% Average money market fund yield: 3.01% Federal funds rate: 3.00% 3-month Treasury bill yield: 2.98% Inflation rate (CPI): 2.70%

Source: IBC / Donoghue’s Nilson Report; Bank Rate Monitor; Federal Home Loan Mortgage Corp.; CPI is year-to-date annualized