The Fed Fuels Overcapacity

Last week's 25-basis-point rate cut was too small, according to most on Wall Street. But a vocal minority believes it was unnecessary and that the Federal Reserve's aggressive policies are contributing to the very deflationary pressures the central bank is trying to forestall.

By keeping the fed funds rates so low, and indicating it won't be raised anytime soon, the Fed has dramatically lowered the cost of capital for corporate America, as evinced by the recent torrent of convertible bond issuance.

History isn't repeating itself, but it is rhyming. When the Fed lowered interest rates in the late 1990s, the resulting liquidity fueled the IPO boom, bringing public a number of companies with questionable prospects. Within the Fed's current policy, convertibles are playing a similar role: allowing many companies that might otherwise have gone bankrupt -- or forced to look for a suitor -- to stay afloat, preventing consolidation in many sectors and curtailing pricing power for all competitors.

But Richard Bernstein, chief U.S. strategist at Merrill Lynch, worries "investors will soon be calling Mr. Greenspan 'Greenspan-san' for his Japanese-like strategy of keeping overcapacity alive," as reported here.

"What's basically happening is Washington in general, not just the Fed, is trying to solve a supply problem" -- really an oversupply problem -- "with demand solutions," Bernstein said in a subsequent interview Friday. "The Japanese have tried for many years to fill up their oversupply with created demand. They haven't been able to do it [and] I'm not so sure we'll be" either.

Bernstein is clearly in the minority among Wall Street strategists -- most of whom view the Fed's policies as reason to be more bullish -- but some share his concerns.

"Unfortunately, there are periods of pain that have to occur in capitalism. They cleanse the system," said Fred Hickey, editor of The High-Tech Strategist. "When that's not allowed to happen, you end up with a messed-up system. The unintended consequence of all this money being thrown at the economy is this overcapacity problem." The most obvious example being the tech sector, where capacity utilization was 62.5% in May vs. a 20-year low of 74.3% overall.