Is the Third Rate Cut a Charm?

A reader sent me an email asking, "Isn't it true that the third rate cut almost always reverses a downturn in stocks?"

As is so often the case in markets, the answer is, "It depends."

The market expects Alan Greenspan to deliver the third rate cut in a row today, following two cuts in January. Whether that will reverse the downturn will depend on whether this third rate cut is a third-rate cut. At this point, only a first-rate cut will do. The market will accept nothing less.

Yes, last week was so savage for so many investors and so many magazine covers feature so many pictures of bears, it's tempting to tell ourselves that we've hit some kind of bottom, almost no matter what Greenspan does today. But that's not true.

Great Expectations

The market firmly expects Greenspan to cut rates by at least 50 basis points . If he does any less than that, expect a collapse like the one triggered last Dec. 19, when the market expected a cut and didn't get one.

If we get only a 50 basis-point cut, then the market's reaction will have everything to do with what the Federal Open Market Committee says in the press release announcing the cut. Feel-good stuff about the economy's recovering in the second half won't wash. If Greenspan repeats the rosy forecasts designed to bolster consumer confidence that have dominated Fed pronouncements over the past month, head for the fallout shelter.

If we get a 75 basis-point cut or larger, then expect an intermediate-term rally. Even though there is a decent chance of a cut that big's being discounted in the fed funds futures , it really would come as a pleasant surprise -- and evidence that Greenspan "gets it" about the risk of recession, no matter what he says officially.

In a 75-plus scenario, expect the stocks that have been beaten down the worst to do the best -- especially at first. Value considerations may come to the fore at some point in a recovery. But there's no doubt in my mind that the Nasdaq will lead the way in terms of percentage gains if an overall rally occurs at all.

Remember, the market already firmly expects a rate cut, yet last week all of the indices broke to new lows. So the magic of the third rate cut alone isn't going to do anything for the markets unless it's accompanied by a surprising level of Fed commitment to staunch the spiral of deflation.

History Lessons

The last time the Fed did that was in November 1998, when a third rate cut put the icing on the cake of Long-Term Capital Management's rescue.

Before that, the most spectacular third rate cut was in August 1982. But then it wasn't just the cut that made the difference. It was the Fed's abandoning its failed four-year experiment with monetarism , under which rate-targeting was thrown aside in favor of targeting the money supply. That experiment triggered an orgy of inflation and led to the shock therapy of the highest interest rates in American history, with the fed funds rate at 20%.

The deflation that followed that era's monetary shock therapy led to cascading defaults by debtors, including Mexico. In August 1982, it defaulted on $60 billion in peso-denominated sovereign bonds, most of which were held by U.S. banks. To prevent the U.S. banking system from seizing up, the Fed threw aside its money supply targets and bought $3 billion in Mexican bonds, amounting to huge antideflationary relief for the economy. That triggered a surge in stocks, which was, in hindsight, the birth of the great bull market of the 1980s and 1990s.

The Fed needs to act now with similar conviction. We've got a "run on the bank" on our hands, with cascading unemployment and debt defaults and a crashing stock market. Only a massive infusion of liquidity -- a la 1982 -- will make any difference. Just another third-rate cut won't matter -- that much is already baked into this sagging cake.

The problem is that we don't have a crisis like the Mexican default or the collapse of Long-Term Capital Management to get Greenspan's attention. I had hoped that Japan's monetary agonies would provide the catalyst, but that crisis-in-the-making seems to have sunk from public consciousness without a bubble.

Land of Rising Hopes

Yet, at the same time, Japan stands both as a frightening warning of how ineffective interest rates alone can be in managing economic recovery -- and, suddenly, as a ray of hope.

The Bank of Japan has now reverted to a zero-interest-rate policy -- something like what has pretty much been in place for the past four years and it hasn't helped. But now the Bank of Japan is talking about zero rates with an important difference. It's talking about targeting consumer prices and buying government securities until prices stop falling. If it follows through, that could be as important a phase-shift in Japanese monetary policy as was the Fed's abandonment of money supply targeting in 1982.

It's not too late for Greenspan to act decisively and boldly with big-time rate cuts. And if he were really bold, he'd start talking about fundamental policy mechanism changes the way his counterpart in Japan is.

But if he takes his usual gradualist path, and this third rate cut is just third-rate, expect a lot more bears on a lot more magazine covers.