In a rare unscheduled meeting on January 22, the Federal Open Market Committee (FOMC) cut the federal funds rate from 4.25% to 3.5%, the largest rate cut in 24 years. The following week, at its regular meeting on January 30, the FOMC cut the federal funds rate a further one-half of one percent.
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At the same time, House leaders and the White House announced agreement on a new emergency fiscal stimulus plan. Still, the financial markets remained unsettled while fears of recession grew with release of reports of slow GDP growth in the fourth quarter of 2007 and the first actual loss in jobs in January 2008.
This, says Dennis Jacobe, Gallup's chief economist, reveals the new limits of the Fed's power to affect the U.S. economy, given the globalization of the financial system. He asserts that the Fed's greatest power right now is essentially the psychological impact it can assert on financial markets worldwide. At the same time, when the Fed takes drastic "emergency" action, it can cause dramatic psychological reactions both domestically and worldwide, leaving the economy highly vulnerable to the law of unintended consequences.
And that's what's happening now. Yes, we're facing a recession, says Dr. Jacobe. And yes, it's probably time to stock the bunkers. But he's not sure that this will be "The Big One" -- something approaching the scale of the recessions of the mid-1970s and the early 1980s. Much lower interest rates could help stabilize the financial markets, and a fiscal stimulus package might soften a major economic downturn. But they might not.
In this interview, Dr. Jacobe explains what's going on with the Fed, how businesses can protect themselves if this turns out to be a major recession, and what managers -- many of whom have never lived through a real economic slump -- should know.
GMJ: Why did the Fed cut the federal funds rate instead of making it easier to get a cheap mortgage loan? Wouldn't helping the flailing housing market have done more for the economy?
Dr. Jacobe: There are a couple of different things going on. The emergency cut in the Fed's funds rate, followed by another cut a week later, has two effects. One effect is to change the psychology of the market. There's been a lot of criticism of [Fed Chairman Ben] Bernanke and the Fed for not being ahead of what's going on in the markets. There was significant instability in the world marketplace in January, so the Fed tried to settle things down with a dramatic, emergency, intermeeting move on January 22, followed by another cut shortly thereafter. Now the Fed has the markets believing it will do whatever is necessary to maintain financial stability and moderate a slowdown of the U.S. economy.
A second effect is that the sharp reduction in interest rates helps banking institutions and other big investment banks; it reduces their cost of funding and creates a more normal and steeper yield curve, where longer term interest rates are higher than shorter term interest rates. So the rate cut can help financial services firms as they work their way through their recent problems, thereby encouraging financial stability. A reduction in interest rates helps the housing and mortgage markets to some degree. So will a change in the Fannie Mae, Freddie Mac, and FHA loan ceilings, allowing more home buyers access to federally backed loans.
Still, none of this really helps with the loan underwriting process. Unfortunately, the tightening of loan underwriting standards is something that needs to happen, and moderating its impact on consumers is not something the Fed can easily address.
GMJ: Will financial institutions pass the benefits they get from lower interest rates on to their consumer borrowers?
Jacobe: Yes. Highly qualified borrowers will find that they will get lower interest rates when they borrow. Small business and other borrowers who borrow at the prime rate probably are helped to some degree. On the other hand, older Americans who live on the interest generated by their investments will find that the interest rate banks will pay to them will be even lower than it has been.
The reality is that banks and financial services firms have been squeezed. They have faced what is called an "inverted yield curve," meaning that short-term interest rates have been higher than long-term rates. This hurts banking institutions because they tend to make money by borrowing short-term at lower rates and lending longer term at higher rates.
In addition, financial services firms such as UBS and Citigroup have posted huge losses on their investments in things like subprime mortgages and some of the more exotic investment vehicles associated with them. As a result, banking institutions need to increase earning power to rebuild their reserves, because they need reserves if they are going to increase their ability to lend. So in that context, the Fed's moves were positive, and they were probably necessary, but they are not necessarily sufficient to stabilize the U.S. economy and calm jittery investors worldwide.
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GMJ: U.S. Treasury Secretary Henry Paulson said that the rate cut shows that "our central bank is nimble and can move quickly in response to market conditions." How do you feel about that?
Jacobe: Well, they're able to move quickly. The question is, do they? And will they? I think the new and somewhat inexperienced Fed leadership simply didn't understand the effect of what was happening in the housing market, along with the impact of other factors like high energy prices and increasing food prices, on consumers. Gallup's polling shows that consumers were feeling more pain much sooner than the Fed, and many others perceived it. So I've thought the Fed has been "behind the curve" for a long time. Now the Fed has finally reacted, with two major rate cuts in a very short time. The problem is that its failure to act more aggressively earlier limits the benefits of its actions.
GMJ: Some people say that the recent rate cuts were the Fed's way of hitting the panic button -- that we're facing some looming disaster that the Fed is scrambling to avert. What do you think?
Jacobe: Psychology has always been a problem for the Fed. If the Fed takes dramatic action, does it indicate that they see the problems and are willing to head them off, or do they just scare people unnecessarily? Are they building confidence, or are they indicating they see something the general public doesn't, thereby making things worse even as they're trying to make things better?
I think what the rate cut really showed, more than panic, is that the Fed decided they weren't acting quickly enough to stabilize the financial markets. The psychology of the money markets was becoming very negative, and the Fed decided to do something to offset it that would have a significant psychological impact. I don't think the Fed is panicking, but its actions certainly were dramatic.
GMJ: Do you think the market pays too much attention to the Fed?
Jacobe: There's an old saying on Wall Street that "You can't fight the Fed." In other words, the Fed can influence investor psychology, so when the Fed is heading in a given direction, you need to invest based on where it is driving the market psychology, not against it -- at least in the immediate term. So no, I don't think the market pays too much attention to the Fed. On the other hand, I do think the Fed has lost some of its potency, and people have learned that over the years, because the Fed doesn't seem to have as direct and as major an impact on the economy as it did in the past.
Globalization has made the actions of other central banks around the world more important. As a result, central banks tend to be much stronger when they act in concert around the world. But more importantly, when interest rates are higher, the Fed's actions have more impact, because when interest rates are high enough to deter corporate and consumer borrowing, then the Fed can influence things by cutting rates. But when the system already has relatively low interest rates, the Fed's ability to affect consumer and investor borrowing and spending is much more limited. Also, when banks are tightening underwriting standards, the availability of money gets tighter regardless of the interest rate level and regardless of what the Fed does.
GMJ: The dollar's weak, and commodity prices are high. Will the rate cuts spur inflation?
Jacobe: It could later in 2008, perhaps early in 2009. I'm not sure that it will. In theory, more money creates more inflation, but there's so much money floating around, there's so much liquidity in the system, I'm just not sure that the current rate cuts will have a significant impact on inflation in the near term. Right now, the inflation situation -- though worse than many policy makers seem to understand -- is a lesser danger than the health of the economy, and I think many people have come to that viewpoint.
GMJ: So then, is this the start of a recession?
Jacobe: Oh, probably. We may be in a recession now. The economy is very weak, and we're in a very slow growth or negative growth period. Gallup's polling suggests that most consumers feel that way, and so do most business people. But we haven't had a recession in so long that I'm not sure people really know what it means.
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GMJ: How bad do you think it will get?
Jacobe: I think the rate cuts and the government fiscal stimulus package will ameliorate it. The effects of sending out checks to consumers may not be long lasting, but they will help moderate the downfall.
It's not clear to me how bad it will get. We haven't had anything that comes close to a severe recession in the last twenty-five years, just some modest downturns. My guess is that we'll see something more like the recession of the early 1990s than that of the mid-1970s or early 1980s. However, if we have a fairly significant recession -- even if it is not of the 1980s proportions -- it will challenge people who have not lived through one, which is everybody under the age of forty.
GMJ: How can consumers and businesses protect themselves?
Jacobe: A major consequence of a recession is that many people become unemployed or underemployed, and we saw the beginnings of this new trend in the most recent jobs report showing a loss of jobs during the month of January. When this happens, consumers become less confident about spending, and they pull back, and that further slows economic activity. It becomes more of a challenge for businesses to make money. There are already some layoffs in the services areas and in the auto industry. We might see more retailers closing stores in the near future.
My advice to consumers is to do everything they can do to strengthen their "personal balance sheet." What I mean by that is that consumers should try to reduce their debts and increase their savings. They should also be very careful about buying big-ticket items that require payments over time.
Gallup surveys show that an amazingly small number of people could handle the financial stress of being out of work for six months or more. In a significant recession, that can happen to a lot of people. Although it may seem shocking, Americans should really think about building enough financial resources so they could make their monthly payments for a period of six months even if one or more household income earners is out of work.
It's not good for the overall economy for consumers to pull back and reduce their spending while increasing their savings. But this is the prudent thing for consumers to do for their own financial well-being when the economy faces a recessionary environment.
GMJ: How would you recommend managers manage in a recession?
Jacobe: Managing during a recession is different than managing during a growth period, and most companies don't have many managers experienced in how to do it effectively. And even for those with recession management experience, things will be more difficult. These days, there isn't as much fat in companies as in the past, and that often was the first place managers used to look to cut costs. So cutting costs will be much harder this time around.
You also have to be much more careful about investing in future growth. In a growth environment, the successful manager anticipates opportunities for expansion, then expands in the expectation that consumers will respond. When facing a recessionary environment, the most successful managers will follow the growth; they will build after the consumer demand has already occurred. You get the sales first, then you respond. So in a sense, you give up the potential benefits of getting out ahead of a potential surge in sales growth, but you avoid the risk of getting out in front of the consumer, because the consumer may not follow along.
One of the best things managers can do is simply go back and look at the basic principles of how you conservatively manage your business. Be more careful about expansion, build cash resources, build your company's balance sheet.
It is a lot less fun to manage in a very slow or recessionary environment. And it is not good for the overall economy if businesses pull back and become more cautious. Still, probably the best thing you can do is look carefully at your balance sheet and do everything you can to make it stronger. Then wait for things to get better. They always do, eventually.
-- Interviewed by Jennifer Robison