The news last week that the Federal Reserve would cut interest rates, ahead of its next official meeting in late January, couldn't have come soon enough for Richard Tomaselli, 50, an insurance broker out shopping near his office in Manhattan's Financial District.
"I have been hoping something like this would happen," he says.
With the Fed's Federal Open Market Committee
giving no clear indication at its December meeting that it was planning to cut rates, Tomaselli was ready to pull his money out of speculative mutual funds and stocks and take a more conservative approach to investing in 2001. If the Fed didn't move, he planned to change his existing pension fund investments and move his money into safer sources of income, like government bonds.
Now, thanks to the Fed's surprise intermeeting decision to cut its key federal funds target rate
to 6% from 6.5%, Tomaselli says he has decided not to tamper with his portfolio. The Fed's move was enough to appease him, but what about the rest of the nation's individual investors? Many have been spooked by poor economic news of late, and seen their portfolios crushed in a long-drawn-out decline in stocks. The question is will the Fed's rate cut encourage them to jump back into the market?
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| An informal survey of office workers taking their lunch breaks earlier this week in Manhattan's financial district showed that many investors had not let the poor performance of the economy hold back their spending during the holiday season, but most were pessimistic about their investments in 2001, despite the interest rate cut. |
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Like Tomaselli, many investors have had their confidence shaken by the ugly market decline of 2000, when they saw their quarterly portfolio statements shrink for the first time in years. Because investor sentiment is a major component in the performance of both the market and the economy, many experts say crushed consumer confidence has killed off the so-called wealth effect -- the idea that consumption increases as rising portfolio values make consumers feel more prosperous (the rule of thumb here is that for every additional dollar in their portfolios, Americans spend another 3 to 5 cents). And so as Greenspan & Co.
try to prop up the economy, the question is, will rate cuts breathe new life into the wealth effect, both encouraging consumers to spend more on their portfolios and to head down to the mall?
Certainly, consumer confidence has been a vital part of the boom, as it has helped to buoy both the markets and the economy over the last few years. More recently, however, poor stock market performance has pushed down consumer confidence.
According to the latest report from the
Consumer Research Center at the
University of Michigan, regarded as an authoritative reading of how Americans are reacting to the slowing economy, the consumer confidence index fell to 98.4 in December from 107.6 in November. That's the fourth-largest drop since the survey went monthly in 1978. The report found that the nation's more affluent families are the most pessimistic, apparently because of the sinking stock market.
Still, news of a rate cut will likely not be enough to encourage investors to jump back into the stock market in great numbers, says Jeffrey Heisler, a professor of finance specializing in investor behavior at
Boston University. "People were desperate for some good news, so perhaps that's why we saw the markets jump so much after the Fed cut," he says. On its own, he adds, the rate cut is not enough to bolster consumer confidence in the long term: "There are corporate earnings numbers coming up, and we might get a couple more weeks of bad news and that could counter the positive effect of this cut."
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| "My attitude was I'm spending now and worrying later," said computer technician Tracey O'Brien, 37. "I told myself I'd be more cautious in the New Year, as the economy would probably be slower." Another computer technician, Jeff Tomer, 35, said he was burned by tech stock investments in 2000, and had decided to opt for safe investing in the coming year. "My investments did well for a while, but when you see a company like Razorfish(RAZF Quote - Cramer on RAZF - Stock Picks) go from $50 to just over $1, you know this market is not coming back any time soon. It was great while it lasted, but those days have gone." |
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In fact, in pure economic terms, there is no historical evidence that shows cutting interest rates has a direct effect on either investors or consumers, says Kevin A. Hassett, an economist and resident scholar at the
American Enterprise Institute. "There is a positive effect on businesses, as it's easier for them to borrow and to get equity to buy machinery. In that sense, it can affect the stock market, but not directly." It can translate into better stock prices for companies, he adds, and that good news can take six months or a year to trickle through to consumers.
Another possible positive effect will be on personal borrowing, says Robert W. McLeod, professor of finance the
University of Alabama. "If borrowing rates go down, then it frees up money for consumers because less money goes to debt servicing, so consumers can either save that or spend it," he says. "There is an impact, but it takes time to work though."
In recent years, with 49% of American households owning stocks, up from about 5% in the 1950s, and the
Dow and
Nasdaq putting on stellar gains (in 1999, the Dow gained 25%; the Nasdaq 85%), American investors have felt happier and wealthier, and this has translated into increased spending on goods and services.
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| Lawrence Johnsen, 48, a reinsurance broker, was more hopeful: "Before the holidays, I was not very confident, but I was positive that my investments in companies with solid earnings each quarter would climb," he said. "Long term the key is performing stocks with solid earnings. I think the Fed cut is helpful, but it's a one-day, one-time event and it's artificial." |
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But just as investors buy more when the market is up, they spend less and save more when their investments decline. The rising stock market built up trillions of dollars of individual wealth by last March, making investors feel wealthier and optimistic.
But the protracted plunge in stock prices since then -- especially technology stocks -- has washed away a great deal of that wealth and euphoria, says Robert Klemkosky, chair and professor of finance at
Indiana University's Kelley School of Business. In terms of crushing consumer confidence, he believes a reversal of the wealth effect could be a big problem: "When stocks tumble, investors tend to retrench and cut down on consumption, and that can slow the economy down dramatically."
And with poor economic news hitting the headlines, investors have little to be happy about these days. In the third quarter of 2000, the U.S. GDP
growth rate fell to 2.2%, its lowest for four years. Car sales are falling, and the index
of the
National Association of Purchasing Management, or NAPM, dropped to 43.7 in December from 47.7 in November (a number under 50 suggests manufacturing is shrinking).
What's more, corporate profits have been crushed by higher fuel prices and slowing sales. And reports are now flooding in from retailers telling of disappointing holiday sales. The reasons: unseasonably cold weather and weak investor enthusiasm due to a sinking stock market.
All this will cause more economizing on the part of investors, Klemkosky says. Worse still, he thinks, it could send the economy into a deeper decline. The result: It could be some time before investors feel confident enough to take the plunge and put their money back into the stock market.
Roland Jones
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