Be Patient: The Fed Cuts Will Work, Just Not Overnight

There was a great deal of chatter heading into Wednesday over how much the Federal Open Market Committee would drop the fed funds target rate. Though most argued that rates would be lowered by a quarter-point, a growing minority cried out for a half-point move.

As it turns out, that debate was a tempest in teapot.

Coming on top of 250 basis points of easing so far this year, it's hard to see what difference it would have made for the economy if the FOMC had taken rates down by a half-point instead of the quarter-point they ultimately cut. The funds rate has come down from 6.5% to 3.75% in a little less than six months -- the Fed hasn't eased this aggressively since the early 1980s. These cuts will either help the economy right itself or, as some worry, they will not.

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An article last week by The Washington Post's John Berry -- a guy who many market participants believe has a good relationship with the Fed -- put forth the skeptics case. He wrote that some within the Fed were "increasingly concerned that unusual developments may be clogging the main channels through which lower interest rates normally stimulate the economy." The dollar, wrote Berry, has stayed strong despite the drop in rates -- something that isn't supposed to happen -- and that's hurting manufacturers. (In fact, the relationship between the dollar and interest rates is somewhat tenuous. HSBC Securities foreign exchange strategist Marc Chandler often quips that "interest rates and currency movements have something to do with each other -- I'm just not sure what.") The stock market has been weak, and the resulting reduction in wealth may be hurting consumer demand.

Most important, long-term interest rates remain high -- in part because of investor worries that the Fed is going too far, thus courting inflation. This curtails businesses' ability to raise money for new capital spending -- not that there'd be much need for that with the tremendous overcapacity in the manufacturing sector. High long-term rates have also left mortgage rates basically unmoved this year. That may be curtailing many homeowners from refinancing mortgages -- after surging early in the Fed easing cycle refi rates have come down. It all translates into less money in consumers' pockets and, ultimately, slower demand.

Berry's piece found its audience: In recent weeks the idea that the Fed might be "pushing on a string" had gained currency, and the idea that some in the Fed might be thinking it, too, helped justify the notion. Yet if "pushing on a string" sounds like a cliche, there's good reason. It gets trotted out every time the Fed does anything on the rate front. (A Dow Jones Interactive news search returns over 300 stories with the phrase in recent years.)

All of the chatter about how rate cuts aren't working, says J.P. Morgan Chase chief market analyst Don Fine, is mostly a sign that "people have nothing else to talk about."

"The fact is it takes time for Fed cuts to start to work," Fine continues. "Yes, 10-year rates are about the same [as when the Fed first cut in early January] and long [30-year] rates are higher. But you'll notice that housing has held its own, durable goods spending has held its own. The lowering of rates at least is creating an environment for the economy to improve once the inventory overhang has been worked off."

Moreover, while longer-term interest rates haven't been coming down, shorter rates have significantly, which can't help but have an effect on the economy.

"There have been significant short-term declines in borrowing costs," says John Lonski, senior economist at Moody's Investor Services. "The one-year adjustable mortgage rate is down sharply. Three-month LIBOR has plunged -- that has the automatic effect of diminishing corporate America's borrowing expenses."

Lonski does concede that the one area of the economy that many investors are focused on -- corporate profitability (and specifically tech profitability) -- will not come back like gangbusters regardless of what the Fed is doing.

"Capital spending is not going to respond much," he says, "if only because excessive capital spending got the economy into its current mess. What the Fed is doing is important in terms of stabilizing profitability, but you're not going to go back to the boom-like conditions that prevailed prior to the slowdown."

Investors still long for that time, of course, and one senses vestiges of the days of accelerated profits and an accelerated time frame in the worries that Fed cuts won't work this time. In the short statement that accompanied yesterday's cut, the Fed addressed the anxiety: "Today's action by the FOMC brings the decline in the target federal funds rate since the beginning of the year to 275 basis points." It's the first time in this cycle the Fed's statement has mentioned the extent that rates have moved.

The message? We've done a lot already. This is going to work. Be patient.