For the third time in the past few months, the Federal Reserve’s Open Market Committee has chosen to cut short-term interest rates by a quarter percent or 25 basis points. The Fed cut its main short-term rate target to 4.25% and the “discount rate” charged on direct Fed loans to commercial banks to 4.75%. In its statement justifying the decision, the Fed noted, “Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks. Today’s action, combined with the policy actions taken earlier, should help promote moderate growth over time.” Will the Fed’s decision help promote “moderate growth?” Knowledge@Wharton asked Jeremy Siegel, a professor of finance at Wharton and author of The Future for Investors, to analyze the Fed’s decision and its impact on the markets. An edited version of the transcript follows.
Knowledge@Wharton: What do you think of the Fed’s decision? Is 25 basis points enough or should they have done 50?
Siegel: If I were there, I would have tried to have gotten 50, but I’m not at all surprised at 25. What surprised me a bit was the retention of the balanced directive. And what that means is that the Fed still sees inflation as a potential problem and did not wish to elevate the slowing economy to a primary position in its policy making. That was a surprise.
Many felt that with GDP growth slowing down this quarter virtually to zero, that the Fed would have put more emphasis on the slowing growth. So, the stock market’s reaction, which is a great disappointment, is not surprising. There is a feeling now that the Fed may be what we term ‘behind the curve,’ which means they are not being preemptive in trying to prevent a recession or a slow down, but they are only being reactive — and being reactive might be too slow.
Knowledge@Wharton: What impact do you think the markets will see going forward, over the next few days?
Siegel: I think that there will be disappointment. This is a drag on the market – to realize that the Fed is not out in front. However, we are going to be getting a lot of data. This is the Christmas season and the incoming economic data is going to start taking on more importance. So, this will be a downer for the market for a few days; but I think that after that, we’ll see how the economy is evolving — and I think this will be very important going forward.
Knowledge@Wharton: With the holiday season here, do you expect to see an impact on retail sales?
Siegel: This rate change really won’t impact anything directly. It’s the mood of the public that is critical. We keep on hearing more and more about the subprime market and the housing market — and if that pessimism builds and consumer confidence goes down further, and it’s already gone down significantly — that could really slow spending. Also, for those people who follow the financial markets, a disappointment in the Fed would also be somewhat of a negative psychological factor.
All of that aside, the truth of the matter is that although Christmas sales are not robust, they are nowhere near a disaster. So, the economy is not falling off a cliff. And clearly, the Fed also does not see the economy falling off a cliff, because if it did, it wouldn’t have downplayed the risks to growth the way that it clearly did.
Notwithstanding, we did get one dissent. The president of the Federal Reserve Bank of Boston wanted a 50 basis point cut. So, there was a division on the Fed and some thought that greater action should have been taken. It’s disappointing that Bernanke couldn’t have gotten a consensus to the slower growth, given that there were clearly some members of the committee who wanted to move more aggressively.
Knowledge@Wharton: You refer to the subprime crisis. One of the things that has made it so unpredictable is that just when one thinks that things are starting to settle down, another shoe seems to drop. How long do you think it will take for the crisis to run its course?
Siegel: If I were a financial firm, I would try to take all of the losses this year, as I have said when everyone is anticipating those losses. It is also my feeling that by the time we get to the middle of next year, some of these mortgages will actually be selling at a higher price than they are today.
In other words, although defaults are high and some of the subprimes are certainly in trouble — we do have prime mortgage securities that are now selling up to a 20% discount. At this [point], there is almost no indication that they are going to be harmed in terms of their cash flow — it is just fear of the market. If fear of the market subsides we could see a rally in these securities next year. So, some of these write downs may actually be reversed.
Nonetheless, there is a loss and everyone who did buy these securities actually deserves to take a loss because they were not good investments. If you really had studied them, you would have realized the risks that were there. So, there are losses in the financial market; these are one time losses and to assess the valuation of financial firms, you of course have to say, “When this is over where do they stand?”
Knowledge@Wharton: In a survey of economists on The Wall Street Journal site today, they said that chances of a recession are now 38%, which is the highest in more than three years. What do you think?
Siegel: I am amazed that people can be as precise as 38%. I remember a few weeks ago when we were in New York and I said that it was 25%. Some of the economists that I respect right now actually say that this quarter is just about zero. But you need two quarters of a negative to get to a recession, and even then it may not be called.
My feeling is that we will still avoid it. I’m disappointed that the Fed couldn’t have done a little bit more. But, I am confident that if the economy does continue to slip — if this quarter does go negative and the first quarter also looks negative — that they will become more aggressive in lowering the rates. That will help the situation substantially. Can they prevent a recession if it’s going happen? Probably not, because if we get a negative this quarter — what they do now, in January and February, probably won’t affect the next quarter too much. But they can shorten the length of it, if we are going to have a recession, and of course help its recovery.
Again, I still think that we are going to avoid it. I think that we are going to be around 1% this quarter and next — and then slightly increase to 2% and 3% by the end of 2008. But clearly there are risks, and certainly there is not an insignificant chance of a recession.
Knowledge@Wharton: When Alan Greenspan was the Federal Reserve chairman, his approach to stimulating the economy, when it slowed down, was to keep lowering interest rates. Now, of course, we see Ben Bernanke doing the same thing. Do you think there is a difference between the way that Ben Bernanke is managing monetary policy and the way that Alan Greenspan did it? What’s the right way to do it?
Siegel: It’s interesting that you bring up Alan Greenspan because I had actually been a critic that he had not lowered the rates fast enough. I am now saying that I wish Ben Bernanke had done a little bit more today. I still think that he’s doing an excellent job and he will catch up.
But Greenspan himself, if you look at his record during the recessions, both the 2001 recession early on and the 1990 recession, he acted very slowly — they were behind the curve. That doesn’t mean there was a disaster. Actually both of those recessions were relatively mild. That’s partly the nature of our economy now … not being as heavily into manufacturing, we’re not going to get quite as big a fluctuation in GDP that’s really structural.
I actually think that every Fed chairman should lower the rates when the economy skids like we have now. And, really in the long run, whether 25 basis points, come here or there, is not a huge difference. If it’s going to happen, it’s going to happen and the Fed will get there. Greenspan did get there — he was never preemptive and although he was known to be a forecaster, he was not ahead of the curve on the two recessions that he faced.
Knowledge@Wharton: Not to politicize the conversation too much, but would you be willing to give an opinion as to which presidential candidate would be best for the economy?
Siegel: Oh wow, it’s hard to say. I think that Hillary Clinton, among the Democrats running, would be the best and the most moderate on her position on taxes and the economy. She is very practical, like her husband was, and I thought that many of his policies in terms of welfare reform and trade agreements were ultimately very, very good. She veers to the left a little bit, but it’s now the primaries. I hope her sentiments stay pretty much focused as her husband’s did when he was president.
As far as the Republicans, I’m not overwhelmed by any of them. I do think that they’re not going to raise taxes and that does worry me. This is because if the Democrats win and that does seem the likely outcome, then you’re going to have a Democratic congress and a Democratic president — and it might be difficult then to stop programs and to stop big tax increases. Americans actually do like a divided government, to some extent, as a check and balance — and that concerns me a little bit. But, among the Democrats, I think that she would be the most practical and the most willing to come to a compromise with the Republicans in some of these major matters.
Knowledge@Wharton: You know, whoever becomes the president, one of the issues that they will have to deal with is oil. Today, in anticipation of the interest rate cut, crude oil futures already hit $90 a barrel. Do you think that this fear, which you referred to earlier about inflation, is likely to become real?
Siegel: You know when they cut it last time and the dollar sunk, I think a few of the members among the bank presidents began to say, “Hey, we are just going to crash the dollar and that’s going to send oil prices and everything that we import up — and that is going to be bad.” I think that that specter was still present at today’s meeting and one of the reasons why Bernanke couldn’t get a consensus that inflation should have been a subsidiary risk to economic growth.
The truth of the matter is that we know that oil came down below $90. This is because what we are seeing now is that the subprime crisis is not just remaining within the United States but it also has implications abroad. There is a slow down internationally, except for the emerging markets which are still going strong. However, there is no question, if Europe and the United States slip a lot, their economies will suffer. They’re still very export oriented, like the Chinese.
Nonetheless, we have had a very significant change in the stance of both the ECB [European Central Bank], the Bank of England, even the Bank of Japan — in that they are now saying that they are looking at the risks of a slowdown. That’s one reason why the dollar actually has done better too recently. The Dow actually rallied on Bernanke’s announcement because they think that he is going to stay firm against inflation. However, if it sends the economy into a recession, they may have wished something else.
Knowledge@Wharton: To end with our usual question: Given the current environment, what strategy do you recommend for investors?
Siegel: Well, the stock market did come back. It was actually, before the announcement, about 3.5% to 4% off its highs. One of the good things I think is that it’s a cushion for stock prices. Probably they are going to get battered today. It is the fact that yields again are so very low. Long-term bonds 4% and below… where are you going to put your money? The long-erm bonds are just not attractive at all.
Real estate is still not attractive at all and that’s going to be a long, drawn-out, slow affair, where I don’t think there is going to be many good investment opportunities — unless you can steal something that someone has to sell. But, there’s not much there. Actually stocks, even with a big slowdown and even with a recession, if you shave those earnings off, are I think are priced attractively relative to bonds.
The bond yield went down 10-12 basis points, at least up until early this afternoon. That means that some portfolio allocations are still moving into stocks, and that’s going to cushion any stock decline. We may have a couple more hundred points off. But my feeling is that we’re probably going to end this month with perhaps an 8% gain on the year. And I look again for an 8% to 10% gain in 2008.