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Fed Nearing the Wall on New Stimulus

After nine rate cuts, stimulating the economy is less about cheap capital than confidence in the future.


Federal Reserve could be nearing the point of diminishing returns in its campaign to relax lending rates.

With nine cuts in the bag and real interest rates already about zero, stimulating the economy is less about cheap capital than confidence in the future and capacity utilization, economists said.

"The latest rate cuts are probably not going to stimulate a lot of net new borrowing," said Steve Wood, economist at FinancialOxygen. "It's really not a cost-of-capital issue for most corporations at this stage. We still have a mass of excess capacity, both domestic and internationally. Business spending is not going to go anywhere no matter what happens to short rates," he said. "On the consumer side it's pretty much the same story."

The problem is excess capacity in both equipment and human resources; the result has been austerity and layoffs, neither of which is solved by lower rates. Layoffs in particular were

mounting in the weeks prior to the attacks, a trend that can strangle demand and exacerbate inventory issues.

"Part of the reason why we have no recovery yet is that this cycle is very different," said Bill Dudley, economist at Salomon Smith Barney. Dudley describes the current situation as a boom and bust, in which "investment spending is not that sensitive to interest rates. It's more about demand and capacity utilization."

U.S. businesses invested heavily in new technology and production during the boom years, but as the economy slowed, so did demand, and now they're stuck with unneeded factory space. The rate of capacity utilization for total industry fell 0.7 percentage point in August to 76.2 percent, a level almost 6 percentage points below its 1967-2000 average.

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Meanwhile, inventories continued to accumulate in July of this year, the most recent month for which data are available. The business inventories-to-sales ratio based on seasonally adjusted data at the end of July was 1.42 compared with 1.40 in July 2000, according to the U.S. Census Bureau. With too much capacity and too little demand, businesses don't need money, regardless of its price.

Pocketbook Distress

What about the demand side, where rates have come way down on most consumer and mortgage loans? Everyone's seen the new ads trumpeting 0 percent financing on cars.

The problem is that consumers are currently busy with two other tasks that suddenly take precedence over buying: servicing existing debt and saving money. As of first quarter, 14.35% of U.S. households' disposable income was used for debt service, up from 13.51% in 1990, according to Federal Reserve Board statistics.

The level dipped in the second quarter but spiked up in August. Meanwhile, personal saving levels, excluding stock and capital gains, have risen to about 4% of income from a low of 1%, partly because of tax rebates and partly because of concerns that existing income is threatened by layoffs. Indeed, personal income growth was flat in August compared with a 0.5% rise in July.

And while mortgage refinancing activity has shot up 600% from a year ago, the mortgage purchase application index is just 1% above its one-year average. Tony Crescenzi, CEO of, blames confidence and income growth and says the trend is worrisome.

"The divergence in the trends of purchase and refinancing activity suggests that while consumers are clearly cognizant of current interest-rate trends, key drivers of the housing market have eroded, namely confidence and income growth," he wrote. "If weakness in home purchases continues, this lack of responsiveness would indicate that interest-rate cuts are not likely to exert all of their intended effects."

On the other hand, if a recovery does materialize, the high rate of refinancing could provide a nice underpinning.

"Lower interest rates will allow companies and consumers to restructure their debts, and put them in much better shape to promote further borrowing and spending some time in the future," said Wood, who predicts new consumer and corporate borrowing won't happen until spring or summer of next year.

During the refinancing boom of 1998-99, the Fed estimated that "consumers tapped into their home equity to the tune of $55 billion," according to Crescenzi. They spent most of it on home improvement and other economically stimulative items. The fear is that this time around, that money might be needed just for survival.