FINANCE-US: Rate Cut Fails to Quell Recession Fears

By Farhan Haq Reprint | | Print |

NEW YORK, Oct 8 1998 (IPS) - Warnings by major US Banks and investment firms of a possible recession in the coming year have grown louder despite the Federal Reserve attempt to stem their worst fears by slightly lowering interest rates.

The Federal Reserve said cut in the federal fund rate – the amount of interest on overnight loans between banks – from 5.5 percent to 5.25 percent was to “to cushion the effects on prospective economic growth in the United States of increasing weakness in foreign economies.”

But a growing number of economists and bankers believe the government and the Fed are not doing enough to respond to the global economic crisis.

On Wednesday, J.P. Morgan became the first Wall Street firm to forecast a recession in the U.S. economy for 1999, predicting no growth for the year’s first quarter, and then output declines of two percent and one percent in the next two quarters before growth is expected to resume at year’s end.

Some consulting firms are similarly worried. DRI/McGraw-Hill, a Massachussetts-based firm, has estimated a 50 percent likelihood of recession next year, while Merrill Lynch economist Bruce Steinberg calculates chances for a recession next year at 30 percent.

Even more worrying to investors were the words of Alan Greenspan. The normally circumspect chairman of the Federal Reserve, who long resisted any interest rate cut in his crusade against inflation, expressed his concern about declining growth.

“We are clearly facing a set of forces that should be dampening demand going forward to an unknown extent,” Greenspan conceded Wednesday. “We do not know how far it will go or how much it will affect consumer and business spending here at home.”

Greenspan argued that the U.S. economy remains strong, with good growth and low inflation, but warned that the stock market’s decline since its Jul. 17 peak has wiped out 1.5 trillion dollars in wealth.

“It’s got to show up somewhere,” he said. “We’re bound to see the major impact in personal consumption expenditures and housing.”

Against this background, economists differed on whether the Federal Reserve rate cut had any real impact at all. The stock market has been volatile since the cut was announced on Sep. 29, indicating that many U.S. investors were disappointed in the conservative one-quarter of a percentage point reduction, at a time of worsening economic crisis in Asia, Russia and Latin America.

“At this point, the markets in Asia are in such difficulty that a rate cut is not going to make much of a difference,” argued Rob Scott, international economist for the Washington-based Economic Policy Institute.

What the economies really need, is some form of “permanent capital controls” to slow the rapid pace of speculation that has drawn billions of dollars out of some emerging markets at a record pace, he said.

The cut however, could have a positive impact for Latin American nations – particularly Brazil, which has been facing “a massive outflow of capital”, Scott said. Brazil therefore could benefit from an action which makes the U.S. dollar relatively cheaper.

Still, Scott added the quarter-point rate cut was a small step, because years of low inflation in the United States have, in effect, boosted the real U.S. interest rate sharply.

For some analysts, however, the important point is not the size of the cut but the signal it sends worldwide – just weeks after U.S. President Bill Clinton declared all nations faced “the biggest financial challenge facing the world in a half-century, and the United States has an absolutely inescapable obligation to lead.”

The Fed’s policy shift, analysts said, showed that the body was adjusting its strict monetary stance to follow Clinton’s lead. “Although regarded by many as insufficient to ignite global demand, this cut is quite significant because it represents a major change in the way the Fed has carried itself,” said Lawrence Goodman and Carlos Camposeco, economists at the Santander Investment firm.

“This institution went from implementing a bias toward tightening to cutting rates in less than six months, which is quite impressive by itself, but has added to it the unprecedented fact that the Fed’s action was more in response to adverse events abroad rather than at home,” the two economists said in a recent report. “This sends a positive signal from the United States in terms of support for the emerging markets.”

Yet few economists believed that the always-cautious Fed would take any dramatic steps, including deeper interest rate cuts, for now. “The likelihood of big interest rate cuts or big development aid right now are remote,” Scott said. “There’s a growing recognition that the system itself has broken down, but the crisis has to hit home.”

Greenspan himself admitted that he had never seen circumstances like the current set of global economic factors. While the U.S. economy was “really still quite an impressive sight,” he admitted Wednesday that “the outlook for 1999 for the U.S. economy has weakened measurably in the aftermath of the Russian devaluation and debt moratorium.”