Fed taking 'long-term' look at boosting economy

By Kathy Helms-Hughes

Federal Reserve Chairman Alan Greenspan told Congress Tuesday that he feels there is room for further decreases in interest rates, already at a 45-year low. However, the more significant change in policy is that the Reserve may be compelled to make a foray into long-term bond markets, according to a local college professor.
Steb Hipple, professor of Economics at East Tennessee State University, said Wednesday that the Fed could go into the financial markets and actually purchase long-term financial instruments from the public sector, and possibly even the private sector, in a move to push long-range interest rates down further.
"Right now, the only interest rates that the Fed controls are the federal funds rate and the discount rate. These are short-term rates. When they go up, the long-term rates, which is the money that's used to buy homes and build factories and office buildings, and stores, highways and schools -- that goes up.
"We want interest rates to come down. All the Fed has worked with in the past has been the short-term interest rates. They cut them and then they hope that the long-term interest rates will decline and that will encourage more consumer borrowing, more business borrowing, and spending," Hipple said.
But recent cuts in short-term rates are not having the desired effect of quickening the pace of economic growth. The Fed cut interest rates by a quarter point, to 1 percent, on June 25. Banks followed suit the very next day, cutting the prime lending rate to 4 percent.
The Fed had predicted in February that the economy would grow at a rate of 3.25 percent to 3.5 percent. That figure now has been scaled back to between 2.5 percent and 2.75 percent.
Adding insult to injury, last month unemployment hit 6.4 percent, the highest rate in nine years. And on Tuesday, the Bush administration predicted that this year's budget deficit would soar to $455 billion, while next year's would top out around $475 billion.
Greenspan, apparently seeing the need for economic stimulus, said Tuesday that the Fed was prepared to leave short-term interest rates at low levels "for as long as it takes." But that may not be enough.
According to Hipple, "The Fed has always had the power to go directly to the financial markets and buy bonds issued by state and local governments, and to buy long-term bonds issued by corporations. There is increasing talk that the Fed -- for what, I think, is the first time in its history of 80 years -- may be compelled to go directly into the long-run bond markets and buy bonds. And when it buys bonds, that will push up the price of bonds, which will then push down the interest rates for those markets.
"A lot of people do not understand clearly that interest rates and bond prices move inverse to each other, so when bond prices go up, that means there has been a fall in interest rates; or if interest rates go up, that means there has been a decline in bond prices," he said.
Not only the Fed, but other central banks around the world are now considering direct intervention in the bond markets. "The Fed has cut the short-term rates about as much as they can. Long-term rates have come down, but they want to see the long-term rates come down even further, so the only way left to do that is to go into the long-term debt market, or bond market, and just directly buy these long-term bonds and that will have the effect of driving bond prices up and interest rates down."
There are also other issues which must be factored in to the economic scene, such as the possibility of "deflation," something which has not been seen since the 1930s Depression. Hipple said though inflation is at a low level, he does not believe a period of deflation -- characterized by a fall in prices -- is in the cards. "The Consumer Price Index is still ticking along at about 2 percent a year, and that seems to be pretty much a floor level for it. We haven't seen it go lower for the past several months," he said.
The bad news is that until the economy gets back up to about a 3 percent growth rate, there will not be any positive impact on unemployment. And though the unemployment rate is over 6 percent, on the flip side, Hipple said, "that means 93 percent of the people in this country are still working."
While the general economy has not been doing well, with lower interest rates, the housing industry has taken off. "It's one of the sectors that really has benefited from the recession, oddly enough," Hipple said.
On the local front, this area is now being impacted by the national recession. "The Tri-Cities is a manufacturing center, and the decline in manufacturing has now affected us," he said.
His forecast for the future is mixed. "There are going to be some bright spots in the area and then there are going to be parts of the regional economy that are going to do poorly. We're really waiting for the overall economy to improve. The best guesses now are that it's going to be well into next year before we see any strong economic performance."
About 20 years ago, one-third of local jobs were in manufacturing. Now it's less than 20 percent, according to Hipple. And though the Tri-Cities is diversifying, it is still primarily a manufacturing center. Until there is a strong rebound in manufacturing both nationally and locally, it will continue to be a drag on local economic performance, he said.
News from Washington regarding the projected $455 billion budget deficit is not as bad as it sounds, according to Hipple. "There are two ways of looking at that. In dollar amount, it's the highest. But when you normalize it against the size of the economy and the level of the gross domestic product, it's still lower than we had in the early 1990s and early 1980s."
The United States' war with Iraq has had some impact on the economy, Hipple said, "But when you are in a $10 trillion economy, the $30 billion to $40 billion that has been spent on the Iraq war isn't much. In the national economy, that's pocket change."
Asked what other factors might play into the current economic downtrend, Hipple said: "A cynic would say it's a Bush in the White House. I'm not trying to be facetious, but the first President Bush had a similar economic performance. He had a recession in the early part of his term of office, and what he did was raise taxes, which guaranteed no recovery. And then in 1992, he lost the election.
"This president has cut taxes, but the tax cuts he has put through are generally going to have a long-run impact, not a short-run impact. So like his daddy, he may go into a second presidential election with a feeble economy," Hipple said.
Bush's supply-side economics include tax cuts primarily for upper income groups. "The argument is that the upper income groups will then save the money and invest it, which means that we'll have more capital formation and that means we will have a stronger economy and a higher standard of living, down the road," Hipple said.
But with an upcoming election year, history could repeat itself.
"The best thing [President] Bush could have done would have been to steal the Democrats' play book and provide rebates and large tax cuts to middle- and lower-income groups, because they would spend that money immediately; and that would give us the short-run stimulus we need to get back to full employment," Hipple said. </