U.S. Economic Outlook: Unclear, but Keep Lowering Those Interest RatesPublished: January 31, 2001 in Knowledge@Wharton
Financial markets, businesses and consumers were surprised and pleased that Alan Greenspan and the Federal Reserve moved to lower interest rates two weeks ago in the face of a weakening U.S. economy. Now, everyone is wondering what the Fed will do for an encore and how the economy and the stock market, especially the battered technology sector, will respond to Fed action, or inaction, in the months to come.
Wharton faculty members offer somewhat different views on just how much the economy is slowing down. But they agree that Greenspan & Co. should lower interest rates again, sooner rather than later.
"Greenspan should be even more aggressive," states finance professor Jeremy Siegel. Siegel says the Federal Open Market Committee should lower the target for the federal funds rate, which is used by banks for overnight loans, by at least 50 basis points at its meeting on Jan. 30 and 31. He says the FOMC should then drop the target by at least another 50 points at its subsequent meeting in March. A basis point is one-hundredth of a percentage point.
The Fed’s unexpected decision to lower the federal funds target rate from 6.5 to 6% on Jan. 3 was the right move, Siegel adds. "It was designed to prevent consumer and business sentiment from deteriorating rapidly. I don’t think it was designed to support the stock market. Clearly, Fed cuts have a positive effect on the market, but I don’t think the purpose was to support the market."
Finance professor Richard Marston also says the Fed should lower rates by 50 basis points at its meeting later this month. "I think the Fed’s action two weeks ago was well-timed, so you have to applaud it, but I’m not sure it’s enough."
Marston says the central bank’s Jan. 3 move was designed to "shock the market and shock the economy back onto a more reasonable growth path. I think Greenspan and the rest of the board may have overdone their tightening and the economy was reacting more negatively than expected in the last quarter of 2000."
Marston adds that the Fed was concerned, among other things, about the decline in consumer and corporate spending. He says the Fed may also have been worried about the state of the telecommunications companies, whose stock prices have plunged, and the spreads on high-yield bonds, which are greater now than during the 1998 crisis involving the hedge fund Long-Term Capital Management. "Wide spreads of high-yield bonds over Treasuries reflect investors’ concerns about credit risk; these spreads tend to rise as the economy weakens." Greenspan personally intervened in that crisis, assembling a consortium of banks and brokerage firms to prevent a potential international shock to markets.
"I would not be at all surprised to find that we are in a recession, which is really disturbing compared with the positive economic outlook of just a couple of months ago," says Marston, who serves on the asset allocation committee of an investment fund. "The fact that Greenspan acted so dramatically shows he’s more concerned than the average economist on Wall Street."
In a recession or in a period when growth slows down, Marston says, productivity growth tends to decline. "The productivity growth we’ve seen in recent years has been the wonder drug that has allowed the economy to do so well in keeping down inflation at the same time that we’ve had low unemployment rates."
Siegel is more sanguine than Marston in assessing the economy. "I don’t believe we are headed for a recession," Siegel says. "Yes, we are in a down period, but we will not produce an outright contraction in the economy. There are some strengths out there. The financial system is strong. Interest rates are low. I think these will help."
President-elect Bush’s proposal to cut marginal income tax rates "would tend to boost disposable income and could have a positive effect on consumption during a time when the economy is slowing," Siegel adds. "Cutting marginal tax rates would also benefit long-term economic growth." But Siegel says he opposes using a tax cut as a tool for "short-term economic stabilization."
Equity prices soared after the Fed’s announcement on Jan. 3, then plunged when, among other things, concerns about corporate profits arose. But stocks have begun to go up once again, giving rise to a question among investors in Internet and technology stocks: Is the new economy a mirage or the real deal?
"We now realize tech companies are cyclical, says Marston. "In periods when the market is doing so well, a whole bunch of tales are spun and people accept them, even intelligent people in the investment community. Back in the 1970s, we had the Nifty Fifty stocks and people were saying Xerox could grow profits indefinitely and could do no wrong. We found that wasn’t true in the bear market of the ‘70s."
Siegel cautions that not all tech stocks are created equal and that it is important for investors to make a distinction between high-flying, profitless Internet stocks and more established technology companies. "There really was a bubble in Internet stocks and that bubble has burst," Siegel says. Other tech stocks may have been overpriced but not as much as, say, electronic retailers with a lot of gumption but poor business plans, few customers and no earnings. Siegel says e-commerce sites that are outgrowths of established bricks-and-mortar retailers are more apt to thrive than pure Internet companies.
"The idea that tech stocks were immune to the business cycle and Fed rate cuts never had any foundation in serious economic analysis," says Siegel. On the other hand, established tech stocks like Cisco Systems, Intel and Microsoft have "taken a beating but are still strong companies with growing earnings and great prospects. Are they worth the [price/earnings] multiples now being sought? That’s an open question."
Marketing professor Peter Fader, who has studied how e-commerce companies market their products and services and has long been critical of the high prices investors have paid for such stocks, says the plunge in stock prices was inevitable.
"I never thought there was a new economy," Fader says. "I never thought the rules had changed. I look at simple indicators of business success: how many people who try a new thing come back and try it again, and how quickly do they do so. If there’s a new economy, those patterns would be changing but they’re not. My take on e-commerce companies is that they are like new toothpastes. Most e-commerce players will fail just like most new toothpastes fail. Is what we’re seeing now a reflection of what e-commerce stocks are really worth, or is the price trough too low? I’m not willing to speculate on an e-commerce stock any more than I’d bet on the future success of a new flavor of toothpaste."
Nonetheless, Fader is optimistic about the long-term prospects for e-commerce. He disputes the conventional wisdom that holds that the "dot-com hares" are losing the race to the large retail "tortoises" that have set up web sites. "People say the Wal-Marts and the Targets are the ones who are winning," Fader says. "But I think e-commerce in general is in its infancy. The history lessons are yet to be written. It’s not even clear that the ultimate winners exist today. There are still so many cards to be played."