NEW YORK — I am not a Grinch.
Thus spake Alan Greenspan on Tuesday at a meeting of community bankers in New York City. The chairman of the Federal Reserve Board signaled that, because the economy is showing signs of a serious slowdown, he is prepared to change interest rate policy from an inclination to increase rates to a far preferable predilection to cut them.
Investors exulted at the news, sending stocks into the stratosphere. The NASDAQ composite index, which at Monday's close had fallen 48 percent from its March high, surged 274.05 points, or 10.5 percent, its biggest one-day jump, to 2,889.80. The Dow Jones industrial average climbed 338.62 points, or 3.2 percent, to 10,898.72. Prices of Treasury bonds also soared, and their yields fell, as investors bought securities that would benefit from declining interest rates.
In early trading Wednesday, the Dow was down 82.67, or 0.8 percent, to 10,816.05, led by International Business Machines Corp. The NASDAQ was little changed up 0.96 to 2890.76.
"In periods of transition from unsustainable to more modest rates of growth, an economy is obviously at increased risk of untoward events that would be readily absorbed in a period of boom," Greenspan said. Nodding to the stock market turmoil of recent months, he added: "In an economy that already has lost some momentum, one must remain alert to the possibility that greater caution and weakening asset values in financial markets could signal or precipitate an excessive softening in household and business spending."
Translation: Even though labor markets remain drum-tight, Greenspan will cut rates to avoid the chilling effect on consumer spending and capital expenditures by businesses that a declining stock market may bring.
Greenspan's comments came just two weeks before the next meeting of interest rate policymakers, on Dec. 19. The Fed chairman's speech makes clear that while once it was true that the economy drove the stock market, today, with households supplanting their savings accounts with shares, the stock market is very much in the driver's seat of the economy.
But even as stock and bond investors celebrated Tuesday, troubling questions remain. Can Greenspan avert a recession or even a hard economic landing with a couple of interest rate cuts? Indeed, how much control do his interest rate levers give him over future economic performance in the United States?
"They are sending a message that they see the weakness and they are responding to it," said Ed McKelvey, a senior economist at Goldman, Sachs. "Certainly the Fed can play a useful role in shoring up confidence through a policy move it might take. But it's not like it's going to effect the cost of credit a whole lot."
Although Greenspan has been credited with steering the economy to its longest expansion on an astute management of interest rate policy, the instruments he has to ward off a recession are relatively blunt ones. Cutting rates by one-quarter or one-half of a percentage point in the first six months of 2001, which is what many economists are now expecting, can only achieve so much. For instance, companies of questionable financial strength must now pay 16 percent annually or more to attract capital from lenders. It will take more than a one-half point cut to reduce these companies' borrowing costs.
"The numbers coming out of the economy this quarter and next are going to be modest numbers," said Henry Kaufman, the Wall Street economist and author. "It is going to require more than a one-quarter point move by the Fed to bring back some momentum to the economy."
Kaufman said that several issues place the Fed now on its most difficult voyage in years. For example, debt amassed by both individuals and corporations stands at excessive levels. Corporate interest payments in the third quarter of this year stood at $182 billion, a record. As a percentage of corporate profits, — at 18.7 percent — these interest payments are not near an all-time high. But if profits recede, debt payments could easily become a problem.
Inventories of manufactured goods are also at high levels, Kaufman pointed out. And with Japan still in economic distress and European economies subdued in their growth, America's ability to export its way out of a slowdown is doubtful.
While the Fed may be able to engineer a soft landing in the early months of next year, it is the second half of 2001 that worries Kaufman. "What will be the drivers in the economy after a period of very modest economic growth?" he asked. "Because of inventories, heavy debt loads, sluggish growth in the rest of the world and the huge amount of capital spending that has already occurred, the answer is not clear."
McKelvey also believes the Fed faces a perplexing dilemma today. "They're starting from a position where the labor market is the tightest in a generation," he said. "If labor costs increase, that can be inflationary. The Fed has to be careful not to ease prematurely."
The most recent figures show that hourly compensation costs among nonfarm businesses rose at a 6.4 percent annual rate in the third quarter, the fastest pace since 1992. And the rise in labor costs has been accompanied by an increase in core consumer prices, growing at an annual rate of 2.7 percent so far this year, up from 1.9 percent in 1999.
This suggests that the euphoria seen among stock investors Tuesday, while fun and festive and a big vote of confidence in Greenspan's abilities, is a little bit more than premature.