By Steven K. Beckner
Market News International - While the Federal Reserve's 50 basis point rate cut was generally welcomed Tuesday, there are those who think the Fed is moving into dangerous territory in terms of its long-term control of inflation.
Bank of America chief economist Mickey Levy accused the Fed of "overmanaging" the economy, "overplaying its hand" and risking its committment to price stability. As if to prove his point, long bond yields rose further in wake of the rate action, suggesting inflation expectations are picking up.
Others, such as Morgan Stanley Dean Witter chief U.S. economist Richard Berner and long-time Fed watcher Charles Lieberman, said the latest Fed action was both necessary and appropriate and does not sacrifice price stability.
It was generally agreed that further Fed rate cuts remain possible and perhaps probable, depending on the complexion of economic numbers prior to the next Federal Open Market Committee meeting in June 26-27.
An intermeeting rate cut is considered much less likely than it was following the March 20 FOMC meeting, when the Fed issued a statement pledging to "monitor developments closely." The Fed subsequently cut rates between the March and May meetings on April 18.
The Fed may even skip the June FOMC meeting and delay further easing until later in the summer, Berner suggested.
The FOMC did as expected Tuesday and decided to cut the benchmark federal funds rate, the interest banks pay to borrow from each other overnight, to 4.0% from 4.5%. The discount rate, at which banks borrow from the Fed itself, was reduced to 3.5% from 4.0%.
What's more, the FOMC left the door open to further rate cuts by saying the risks remain weighted toward "economic weakness."
It was the fifth time this year the Fed has cut rates for a cumulative 250 basis points of easing.
In explaining the latest cut, the Fed said weak business investment in capital equipment, slower growth abroad and the negative effects of past stock market losses on consumer spending "continue to weigh on the economy." With unemployment easing, the Fed statement suggested that inflation is not a near-term concern.
As it has in previous statements, the Fed began in a more positive vein, observing that "a significant reduction in excess inventories seems well advanced" and that "consumption and housing expenditures have held up reasonably well, though activity in these areas has flattened recently."
The Fed announcement then turned to the real nub of its rate cut decision. "Investment in capital equipment, however, has continued to decline," it said.
"The erosion in current and prospective profitability, in combination with considerable uncertainty about the business outlook, seems likely to hold down capital spending going forward.
"This potential restraint, together with the possible effects of earlier reductions in equity wealth on consumption and the risk of slower growth abroad, continues to weigh on the economy," the statement added.
With some Fed critics, as well as many bond market participants, worried about the implications of aggressive Fed easing for future wage-price behavior, the Fed statement addressed the issue head-on. "With pressures on labor and product markets easing, inflation is expected to remain contained," it said.
The statement also dealt with the first quarter drop in productivity growth relative to longer term trends in output per hour worked.
"Although measured productivity growth stalled in the first quarter, the impressive underlying rate of increase that developed in recent years appears to be largely intact, supporting longer-term prospects," it said.
Bank of America's Levy made clear he was not impressed by the Fed's statement about inflation. A member of the Shadow Open Market Committee, he took up where that committee left off two weeks ago in castigating the real open market committee.
Despite economic weakness, Levy observed that "core inflation has drifted up" and with it long-term interest rates. He said the Fed is wrongly committed to a "Phillips Curve" concept of a trade-off between inflation and slow growth. What matters, he said, is that "money growth is continuing to accelerate."
Levy said he thought the previous four Fed rate cuts, which left the funds rate at 4.5%, had been appropriate, but said the move to 4.0% signifies the Fed is "overmanaging things" and pumping too much liquidity into the economy, and the Fed will ultimately "have to drain it back out."
"They're making a bet that consumption is going to collapse, but I don't think consumption is going to collapse," said Levy, adding, "They're overplaying their hand."
Levy, whose bank cut its prime lending rate to 7.0% from 7.5% soon after the Fed announcement, nevertheless said he sees continued easing. He said he would expect the Fed to now "move to a more gradual policy of 25 basis point cuts," but added, "I hope they're close to the end."
Others were more charitable toward the Fed. Berner, who is also president of the National Association for Business Economics, said the Fed is correct in its view that inflation is apt to remain contained and said the Fed has been justified thus far in easing aggressively.
"This has been one of the more uncertain economic environments" the Fed has ever faced, and the risks of easing too little outweighed the risks of easing too much, he said.
However, Berner said as and when the economy rebounds the Fed must "be willing to take back" some of the rate cuts.
And Berner said he believes the Fed is now close to the end of the easing it needs to do. He said he envisions only one more 25 bps rate cut being needed, taking the funds rate to 3.75%.
He said "it is entirely possible they will pass in June if they get mixed economic signals."
Former Fed vice chair Janet Yellen said in a CNBC interview that, "It's very clear the Fed remains concerned about downside risks ... They're clearly ready to ease more."
Having cut rates 250 bps, the Fed has brought real short-term interest rates "closer to zero," Berner said, adding "they're getting to the point where policy is stimulative. It's time to take stock, slow the pace and even end (the easing) at some point."
Another reason for the Fed to ease more gradually is the prospect of tax cuts, Berner added.
Former Fed governor Bob Heller agreed future rate cuts were likely to be smaller.
"What the Fed has achieved so far is a neutral monetary policy," he said in a CNBC interview, adding "any further cuts would be stimulative." Therefore he said he expected any future cuts to be "smaller."
Lieberman, a principal in Advisors Financial, said the Fed rate cut was "necessary and perfectly sensible" in wake of the April employment report, which showed a 0.2-point rise in unemployment to 4.5% and a 223,000 decline in non-farm payrolls.
Lieberman said the May employment data "will determine whether the Fed cuts rates at the very next meeting in June" and by how much.
Lieberman said the Fed statement on inflation was "exactly right. You can't worry about economic weakness and inflation simultaneously. It makes no sense to try to do that."
While lowering short-term rates, the Fed rate cut sent Treasury bond yields higher, and the implication was that longer-term mortgage and other rates would go higher, not lower.
However, Berner pointed out that corporate bond issuers have not really been hit by the rise in government bond yields and the steepening of the yield curve because spreads between corporate and Treasury yields have narrowed.
Besides, Berner and Lieberman observed, business should benefit from cheaper short-term money as the prime rate and commercial paper rates come down. Some of those borrowing cost savings could be passed on to consumers, for instance auto purchasers, Lieberman said.
Consumers are likely to get little or no relief on steep credit card rates, but should benefit from lower borrowing rates for equity credit lines and other personal loans tied to the prime, Lieberman said.
Would-be home buyers or mortgage refinancers also can take advantage of cheaper short-term fixed rate home loans and adjustable rate mortgages, he said.