Preferred Isuues: Lenders Felt Jan. Rate Cuts — Last Year

The debate over the merits of a retroactive tax cut as economic stimulant must make Federal Reserve Chairman Alan Greenspan wish he had a similar kind of time-travel tool for interest rate policy.

Or maybe we’ve already seen the first episode of a new era of retroactive interest rate cuts.

Conventional wisdom states that there is a lag of six to nine months between a monetary easing and a corresponding boost to economic activity. By firing off back-to-back rate cuts of 50 basis points in January, the Fed signaled that in terms of protecting the economy, time was of the essence.

The behavior of interest rates, capital markets, and Fed officials last year offers plenty of reason to believe this lag time between rate cut and stimulus will be shorter. If so, the Federal Reserve in essence will appear to have achieved the impossible: starting the clock on a rate cut months before actually pulling the trigger.

Financial markets’ tendency to anticipate events like changes in interest rates and to price accordingly is not a new phenomenon, by any stretch. But this time even corporate managers, who operate in often much stricter confines when planning borrowing for capital projects, seemed to share the ability to anticipate the future.

Evidence abounds that potential borrowers did a fairly good job of predicting the Fed’s rate cuts. A quarterly lending survey by Phoenix Management Services of middle-market lenders reinforced the findings of a Fed survey that showed a trend toward tighter lending standards. In addition, and contrary to the Fed’s findings, two-thirds of respondents said they expected middle-market and small-business lending to increase in the first quarter.

Perhaps some of that is pent-up supply and demand, given the widespread expectations among borrowers late last year that lower rates were coming. “People have been anticipating that the Fed would be doing something for several months,” said Tracy Lefteroff, global managing partner in the private equity and venture capital division for PricewaterhouseCoopers in San Jose, Calif.

When tech stocks entered their meltdown last spring, financial markets quickly did most of the work of pulling down the borrowing rates that matter most on a bread-and-butter spending level, said Russell Sheldon, vice president and senior economist at BMO Nesbitt Burns. “In contrast to back in ’89, when market rates stayed stubbornly high [despite Fed rate cuts], this time we already had a pretty large decline in market rates.”

So when Mr. Greenspan (who seems to offer up his signature speeches in Decembers) chose to voice concern last Dec. 5 about excessive tightening in credit standards by banks and then followed up with aggressive easing, he was effectively “validating” the work done by the markets, said Mr. Sheldon.

Even with the advance work, 100 basis points in a couple of weeks had shock value. “My impression was [the first 50] scared people to death, but I don’t think he had a choice,” said Mr. Sheldon. “It was alerting the optimists in the private sector” that conditions had changed dramatically.

Now, with a second move completed and further easing likely, expect the next phase of managing expectations to begin. The objective: managing the fear of a recession to avoid the possibility that fear itself will trigger the recession everyone fears.

“If you look at every single Fed speech in the next couple of weeks [after the last rate cut], it made that very point — that conditions weren’t that bad,” Mr. Sheldon said. “And when Greenspan testifies to Congress, I expect he’ll continue to try to walk a fine line.”

The extra work may be the downside of managing expectations. As Americans apparently deferred income to 2001 in the hope of a retroactive tax cut, businesses may have deferred borrowing. Expectations of a rate cut may have applied pressure to the banking system’s brakes even as the Fed argued guardedly for a firmer foot on the accelerator. Guardedly, because all is not rosy in the world of credit.

There are pockets of weakness in manufacturing, some areas of technology and other segments that warrant attention. It’s just as true, however, that some areas in no apparent trouble at all are taking a hit that may not be rational, said Mr. Sheldon.

“This has been extremely contained; it’s not a widespread free fall by any means,” he said. “If you look at office space, vacancy rates are at all-time lows, credit quality for office construction has not declined, and there is a real need for space.”

Real estate, the poster child for what went wrong last downturn, is one area where lending activity appears to be slowing fastest. Averting an oversized delcline may well require full complements of monetary stimulus and psychological support. Preferably yesterday, of course.