Pushing On A String

THE BE YOUR OWN ECONOMIST ® BLOG

Today the Federal Reserve reduced the federal funds rate – the rate at which banks lend reserves to one another – by half-a-percent to one percent.

The following paragraph is an excerpt from the Fed’s statement (http://www.federalreserve.gov/newsevents/press/monetary/20081029a.htm):

“The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit. “

In other words, we’re in for a bad recession.

Will the Fed’s rate cut pull us out of the ditch?

Unfortunately today is not 2001. Back then, as the dot-com recession unfolded, the Fed reduced interest rates in order to stimulate borrowing and spending, and thereby revive the economy. Real estate responded by generating the housing bubble whose collapse is responsible for the current debacle. It does not seem likely that reducing rates today will instigate another building boom. Home prices keep falling as the market attempts to absorb the leftovers from the earlier glut. Until that process winds down, lower rates can not help much.

This problem is replicated throughout the economy. Motor-vehicle sales are heading south because households wish to repay debt and preserve liquidity. For many this is not the right time to buy a car no matter how low rates have fallen. Businesses seem to be cutting back for the same reason. Few see today as the right time to invest in additional facilities and employees. Quite to the contrary, employment is falling as layoffs rise.

Economists once said that interest rates are like a string – far better at holding the economy back than pushing it forward. That proved to be incorrect in 2001. It may be correct today.

© 2008 Michael B. Lehmann