The financial markets have cast their vote for a 50-basis-point interest rate cut. In the days leading up to the Federal Reserve's two-day meeting that began Tuesday, Fed officials were trying to talk expectations down. They've been telling anyone who will listen that a 25-basis-point cut is still a real possibility. Whatever the Federal Open Market Committee does Wednesday, however, all of us -- Fed policymakers, CEOs, retirees, investors and consumers -- are about to begin a journey into uncharted economic and monetary territory. Let's hope it doesn't get too exciting. If the Fed cuts the federal funds rate -- now at 1.25% -- to 1% or 0.75% with a cut of 25 or 50 basis points, the real rate would be deeply negative. With core inflation running at 1.6% annually, the real federal funds rate could be a negative 0.85. Money market accounts, which currently pay just 1.35% on average (a negative return when inflation is factored in), are likely to drop even more into the red. The three-month Treasury bill is already paying just 0.8% in anticipation of the Fed's move. The Fed's stated goal is to provide enough liquidity at a low-enough price to get the economy rolling again at something above the 1.9% growth in U.S. gross domestic product recorded for the first quarter of 2003. But no one knows what kind of unintended consequences cutting interest rates to 1% or less will have as the rate cuts ripple through the global economic and monetary systems. Let's look at five areas where the unintended effects are largely unknown but could be huge.
But preserving that price is an increasing strain on mutual fund companies. Even though these funds are now paying almost nothing in interest to their investors, they also earn almost nothing themselves on their own short-term investments. For example, the Schwab Money Market Fund shows a portfolio with an average maturity of 60 days. Money market funds have to be invested in this kind of short-term paper, because investors can withdraw money at any time. Yields on this kind of investment, though, are often already below 1%. Commercial paper directly placed by GE Capital yields just 0.95% on maturities of 46 to 77 days. Schwab charges investors 0.79% in operating expenses on this money market fund. No wonder the Schwab Money Market Fund is paying just 0.51%. But those numbers show the squeeze that's ahead if the Fed sends short-term rates much lower. Either Charles Schwab ( SCH) will have to cut the yield on the fund, making it harder to attract investors, or it will have to cut its expense ratio. That's not exactly an easy choice when Schwab has $121 billion in money fund assets.
Xerox ( XRX), for example, just issued $700 million of seven-year notes paying 7.13% and $550 million of 10-year notes paying 7.63%. Certainly this financing improves liquidity at Xerox, but this is still a company fighting for its life. That 7.63% yield will look great if nothing goes wrong with the economy (and interest rates don't rise) by 2013, but it isn't a lot to collect for the risk that investors in these bonds are taking on.
Adding a little more fuel to equity prices will give consumer confidence another boost as investors start seeing black ink on their quarterly financial statements. And increasing equity prices will help corporations trade equity for debt on their balance sheets, improving corporate profits and providing cheap money again for investment in capital equipment. At least that's the way the story is supposed to go. Apologies to Mae West, but too much of a good thing isn't always wonderful. The potential unintended consequence in this case would be to reinflate the bubble in financial assets before it has fully finished deflating from its maximum expansion in 2000. If corporate spending on real assets doesn't pick up, the liquidity that the Fed is adding to the economy, plus its nudge to move investors from bonds to stocks, could send stock prices climbing again without support from improving economic fundamentals. The danger here is that with capacity utilization about 74% in May, corporations won't see a need to increase capital spending. And that will leave a lot of dollars chasing financial assets.
But those partners, especially the ones that have built their economies around exports, can't afford to see their products priced out of the U.S. market. So they sell yen or Deutsche marks and buy dollar-denominated assets such as Treasury notes to strengthen the dollar against their own currencies. How long can these foreign central banks keep this up? As long as they've got ink and paper to print more money. And as long as the political winds say that the risk of future inflation is more than offset by the rewards of current employment. U.S. exports should get a modest boost, but the dollar probably won't sink too much further from current levels. These are just the possible unintended consequences from a conventional interest rate cut of 25 to 50 basis points. Be prepared.