Do Rate Cuts Help?
By Matt Richey (TMF Matt)
June 24, 2003
Will it be 25 or 50 basis points? That's the question most of the financial media is hovering over in anticipation of tomorrow's policy announcement from the Federal Reserve Open Market Committee. So far, Fed watchers are torn over which outcome is more likely.
The more important question, however, is this: How long will the financial markets hang their hopes on yet another rate cut? We've already had 12 cuts since January 2001, and the federal fund rates is at a measly 1.25%. Short-term interest rates are already lower than anytime since 1958. Let's face it, the rate-cut lighter fluid just isn't stoking any economic flames.
The problem isn't a lack of credit, but too much credit. Easy and abundant credit has caused the economic logs to be inexorably soaked with excess capacity. You can see this in the capacity utilization figures, which recently have been stuck at a 20-year low of less than 75% (where anything below 80% prevents new investment). There's no amount of easy money that can inspire businesses to build what's already been over-built.
What the economy really needs is a reduction in capacity via bankruptcies of marginal companies. Obviously, such a notion is politically unspeakable, but it's the destructive side of capitalism that frees resources to fuel the business cycle's next constructive phase. As it stands now, though, marginal players can't go out of business because so much easy money is sloshing around.
Everyday, we hear about companies "strengthening their balance sheets" through lower-rate financing, as if that's supposed to be good. It's good to a point, but not when it allows companies that should go bankrupt to stay alive. When less-efficient companies stay alive, their more-efficient competitors get less business. For any given industry where this dynamic is at play, the result is less efficient, overall average production. Extended economy-wide, inefficient production leads to below-potential output, or subpar economic growth.
Nevertheless, the Fed is committed to its course of trying to stimulate demand rather than allow supply to contract. One can only hope that the Fed's easy-money policies begin to work before zero-interest rate scenarios come into play. If interest rates go to zero, the Fed won't have any traditional arrows left in its quiver. And the last thing anyone should hope for is the use of unconventional (that's a kind word) policies such as those recently explored by the Dallas Fed.
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