As if the rest of today's news weren't enough, the Federal Reserve dropped the federal funds rate -- already at a 40-year low -- by a full 0.5% (50 basis points) to 1.25%, and the discount rate to 0.75%.
Rate cuts are designed to entice businesses and consumers to spend more. Apparently, the 11 rate cuts in 2001 were not sufficient, so here we go again.
Yet the economy is nowhere near its worst point in the post-WWII period. Certainly the oil crisis in the early 1970s and the stagflation going into the early 1980s were much worse. Housing prices and starts are still solid; unemployment rates are nowhere near their highs; and there's no inflation in sight. And yet, interest levels are now lower than they were during either of those times, or any other period of recession.
It has been the habit of stock market commentators to say that rate cuts are "good for the market." It has also been the habit of the stock markets to surge on the news of each rate cut. These surges have not been sustained, and seem to be nothing more than reactions to the fact that everyone else thinks rate cuts are good for the market. This has failed to bring about a sustainable rally in the market 11 consecutive times, yet that doesn't keep people from hoping this time's the charm.
Permissive monetary policy ought to be good for the economy. Since the stock market is an economic beast, the assumption that it would benefit from lower interest rates is more than reasonable. But saying the rate cut is good for the stock market is sort of like saying higher coffee prices in Nigeria directly affect your morning cup of java at Starbucks
The long string of lowered rates makes one wonder about the paltry returns being generated by the hundreds of billions in cash "sitting on the sidelines" awaiting a stock market recovery. Bank interest rates on savings have dropped precipitously in the last two years. Couple this with the statistic (also from the Federal Reserve) that the average family has more than $13,000 in consumer debt, and you begin to see the effect of overspending on the overall economy. People did it; companies did it; and now the economy is weak because much of America is in debt up to its eyeballs, and the only real leverage the government has is to encourage us to spend more.
The Federal Reserve sees significant hidden strength in the economy. In its comments today, the Federal Open Market Committee stated that it "continues to believe that an accommodative stance of monetary policy, coupled with still-robust underlying growth in productivity, is providing important ongoing support to economic activity." Instead of calling the economy "recessionary" or "weak," they opted for the euphemistic "soft spot."
In short, investors should recognize that, while rate cuts are designed to add liquidity and buoyancy to the economy, they are blunt instruments. If the economy has significant issues to work through, such as tremendous amounts of debt (brought about by previous permissive monetary regimes), this may speed up the process, but it is by no means a cure-all.
