In the annals of Federal Reserve history, 1998 probably will be recorded as a year of great success for the nation's monetary policy.
Fed Chairman Alan Greenspan and his colleagues were credited with averting an international economic depression by cutting US interest rates. With Asia in crisis and Russia's meltdown troubling the globe in fall 1998, the Fed cut rates three times. The success of the exercise won Greenspan a place on the cover of Time magazine as part of the "Committee to Save the World." He also was a runner up for Time's person of the year honor.
With the benefit of hindsight, 1998 also can be remembered as a year when the Fed made one of its bigger policy mistakes. While equity investors who prospered from the bull market in stocks that resulted from the Fed's actions in 1998 may not agree, even some Fed staffers think that third rate cut was a mistake.
The US roared ahead, asset values surged to record highs and the Fed had to raise rates in 1999 and 2000 to quell the euphoria.
The lessons from that experience provide insight into why the Federal Open Market Committee (FOMC) only cut a quarter-point from its overnight lending rate last week, rather than a half-point.
"It seems that the FOMC has judged that it's those last couple that can bring on a headache the next morning, so it's best to take it slowly," says Rory Robertson, interest-rate strategist at Macquarie Bank.
Policy makers, especially the more hawkish ones, probably want to avoid executing rate cuts that they'll have to take back six months from now. It's possible that the economy will roar back in the second half of the year, thanks to the Fed's rate moves and the recently enacted US$1.35 trillion tax cut. And the resulting volatility in interest rates could do even more harm to the economy.
Some officials feared as much as far back in May, when the Fed executed its fifth 50 basis-point cut of the year. A summary of the Fed May 15 FOMC shows that three members favored slowing the pace of rate cuts. The reason was that a 1998-like rebound could ignite inflation. The fact energy prices have risen markedly this year only exacerbated such concerns. As recently as mid-May, policy makers "suggested that the Fed could be through cutting the funds rate soon," says Martin Mauro, a senior economist at Merrill Lynch & Co.
It's also possible that the US will remain sluggish if businesses and consumers -- both weighed down by mountains of debt -- rein in spending. This concern explains why the central bank may cut rates again in August. Yet it's clearly nearing the end of its campaign to revitalize the economy.
One of the clearest suggestions of this was the Fed's decision to incorporate a running total of its rate moves this year in the statement accompanying last week's rate cut. By mentioning they've gone 275 basis points so far this year, policy makers seemed to be saying "we've done a lot already and now we want to see what happens."
That gesture, however, coupled with the Fed's more modest 25 basis-point move, may end up being the most potent of all. This flies in the face of conventional wisdom. The bigger the Fed's move, economics textbooks tell us, the bigger the effect on the economy.
By taking its most gradual step this year, Wednesday's rate cut seemed to do more to buoy optimism on the economy than the others. The reason? The lack of panic at the central bank.
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