Why the Slump Lasts
The sixth interest-rate cut of the year by the Federal Reserve may not be any more successful in stimulating the economy than the others. It does not correct the mistakes made in the past and mend the imbalances in economic production; it may not restore investor confidence and prevent economic output from slipping into a recession.
The deterioration of corporate profits suggests that the worst is yet to come. In contrast to several previous recessions, the present situation is complicated and aggravated by two threatening events.
First, economic activity in several countries in Europe, South America, and Asia is sagging along with the American economy, which forebodes a worldwide recession. In the past, a decline in the United States usually was mitigated by boom conditions in Europe and Japan. And when the Japanese and the European economies fell into recession, the American economy functioned admirably as a powerful locomotive for all.
Second, inflation presently is raising its head in many countries. American consumer goods prices in May rose at an annual rate of 3.6 percent, and long-term bond yields are signaling more inflation ahead. Consumer prices presently are rising in the Euro area at a 3.4-percent rate, in Canada at 3.9 percent, and in Mexico at 7 percent.
In several developing countries, consumer prices are climbing at double-digit rates—10 percent in Indonesia, 12 percent in Venezuela, 25 percent in Russia, and 50 percent in Turkey. Inflation and sagging output are kindling fears of "stagflation," which was the primary disease of the 1970s.
This places the Federal Reserve between the proverbial rock and a hard place. If it reduces interest rates further in order to stimulate the economy, it is bound to exacerbate the inflation; if it boosts the rates in order to fight inflation, it will aggravate the recession and raise unemployment; and if it chooses henceforth to leave the rates unchanged, it undoubtedly will draw the wrath of many media commentators.
The six interest-rate cuts actually have done little to bolster economic activity. They managed to lower the federal-funds rate, which is the rate at which commercial banks lend their reserves to one another. But this rate may not affect the economy, since neither businesses nor consumers pay it. The transmission through which changes in the federal-funds rate drive economic activity is forged by the laws of the market. They are immutable; Fed manipulations do not sway them. Fed monetary policy is supposed to "stabilize" the economy and promote economic growth. It acts through four channels of transmission:
(1) It lowers the cost of borrowing in order to spur consumer spending. But its intention may be thwarted by economic uncertainty, which discourages indebtedness. The fear of a looming recession may even induce debtors to reduce their debt even though interest charges should come down by a few percentage points. Moreover, in adversity and uncertainty, creditors tend to boost interest rates to compensate for the growing risk. While the Fed pushes hard to lower rates, the market may oppose and mitigate the effects.
The six rate cuts totaling 2.75 percentage points actually have had limited impact on credit markets. They succeeded in reducing the prime rate from 7 percent to 6.75 percent and the average rate on credit cards from 17.1 percent in January to 15.5 percent today. Yet, consumer spending has been contracting throughout the year, from an annul growth rate of 4.5 percent to a rate of 3 percent in the first quarter and 1.5 percent in the second quarter—and the decline is continuing.
Average credit-card debt, now estimated at some $7,500 per household, is weighing heavy on consumer spending. Moreover, the credit-card interest rate, which primarily consists of a debtor's risk component, is bound to rise again as unemployment increases and economic uncertainty raises all market rates. If the Fed attempts to hold them down, it will have to lower its rates even further and expand credit at accelerating rates.
(2) Fed rate reductions are to spur business spending, which is the power source of the business cycle. But they only minimally affect business borrowing, which is guided by bond and mortgage yields rather than short-term rates. Market expectations about inflation constitute an important component of all long-term rates; in inflationary times, they tend to thwart Fed policies.
The 30-year mortgage rate has barely moved since the Fed began slashing rates, hovering at about 7.13 percent. Long-term rates embody not only the basic value difference between present and future funds but also the expected inflation rate during the life of the security. When the Fed embarks upon easy-money policies, short-term rates indeed tend to decline, but long-term rates may rise in anticipation of future inflation and bond depreciation. Massive Fed credit expansion undoubtedly would cause short-term rates to plummet and long-term rates to soar.
(3) The Fed seeks to affect economic production through changes in the dollar exchange rate in international markets. By reducing the federal-funds rate, it hopes to lower the U.S. dollar versus other currencies and thus boost American exports. But international money markets may actually lift the U.S. dollar because other central banks may depreciate their currencies at faster rates.
The European Central Bank, for instance, is about to embark on a currency reform that is designed to seize and confiscate hoarded savings. It is not surprising that many European savers are seeking refuge in U.S. dollars, which is lifting them to astonishing levels. Another important central bank, the Bank of Japan, has been keeping its rate near zero for most of a decade while the Japanese government, engaging in massive deficit spending, managed to increase its debt to some 135 percent of gross national product. In competition with such currencies, the U.S. dollar is bound to shine brightly despite the Fed having cut its rate by 2.75 percentage points.
(4) Fed monetary policies seek to affect the economy through the prices of financial assets, especially equities. Lower interest rates hopefully lift share prices, which usually induces wealthier stockholders to boost consumer spending and invest some funds. Yet the market, which is driven by the judgments and actions of countless individuals, may discount the Fed intentions and bring forth the opposite.
Since the Fed first set upon its rate-slashing course in January, the S&P 500 has actually fallen by some 10 percent, the trade-weighted U.S. dollar has gained 7 percent, and the bond and mortgage rates have remained unchanged. The Fed's cure-all for economic ailments is spending—consumer and business spending. It may even urge the federal government to embark upon deficit spending in order to stimulate the national economy. But lack of spending has never been the cause of a business cycle, nor can spending be a remedy. Great variations in public spending are mere symptoms of a cycle that actually is a sequence of business maladjustment and subsequent correction.
It is the inevitable consequence of Fed interest-rate manipulations to disturb, disrupt, and disarrange economic activity. They are the force majeure that spawns the business cycle. The laws of the market act upon the interest-rate manipulations and may magnify or counteract them and even effect the very opposite of what the Fed meant to achieve.
The Fed may actually aggravate a decline and delay the recovery. Guided by its ideology of spending, it may push reserves into the banking system, but the banks may not lend them out because the low interest rates do not cover the lending risk. The zero-rate policy of the Bank of Japan is a current example of a fatuous prevention of economic recovery.
When, for any market reason, financial institutions hesitate to lend their funds, the Fed's efforts are bound to be futile. Fed observers call it "pushing on a string," mainstream economists wax about a "liquidity gap," and market economists point at "Fed machinations and economic maladjustments." Government planners and central bankers always tell us that business cycles are ailments of the unhampered market order and that only they can master them. The present decline demonstrates anew that their explanations are not only self-serving but also misleading.
See also Murray N. Rothbard on The Origins of the Federal Reserve.