Interest-rate cuts, by the bushel

World's central banks act in near-unison to fend off a recession. But will Fed cut be half a point, or one-quarter?

The Federal Reserve is poised to slash interest rates again tomorrow, in an anti-recession fight that is increasingly being taken up by the world's other central banks.

The Fed action, coming after several similar cuts since January, would mark the biggest interest-rate drop in a short time span - less than five months - in 17 years.

The sense of urgency is matched abroad.

In an uncoordinated and unusual convergence of policy, central banks in the major industrialized nations are all cutting interest rates - at last pulling together to try to drag their economies out of harm's way.

From Japan to Europe, concern that monetary ease might bring back higher inflation has, for now, been pushed aside for fear of a worse evil: global recession. The concern is symbolized, in the United States, by a steady, upward creep in unemployment, which in April hit 4.5 percent.

Yet, with signs of surprising strength in US retail sales and consumer confidence, there is some debate about how much further the Fed's rate cuts will go.

"I would bet the US will get through this [slowdown] OK and see pretty solid economic growth by the end of the year," says Martin Baily, chairman of the Council of Economic Advisers under President Clinton. Still, he says, "There is a great deal of uncertainty."

Last Thursday, the European Central Bank surprised financial markets with a quarter-point interest-rate cut for the 11-nation euro zone.

Forty-five minutes earlier, the Bank of England did the same for Britain, which remains outside of Europe's currency union. The Bank of Canada is expected to ease rates when its policymakers meet May 29, if not earlier.

And last month, the Bank of Japan dropped interest rates to zero. It also promised to pump more money into the island nation's economy to end years of stagnation and deflation.

These moves promise to be a helpful stimulus. But American economists remain riveted on the Fed itself. It has already cut short-term interest rates two percentage points since the start of the year. Financial markets generally expect a half-point cut at tomorrow's meeting in Washington, and perhaps another one-quarter point in June.

But on Friday, a report showed US retail sales jumped 0.8 percent in April, after falling for two months straight. And the University of Michigan's index of consumer sentiment also rose, snapping a streak of declines.

Debate about size of cut

The news prompted a few economists to speculate that the Fed could shock Wall Street by trimming interest rates just a quarter point.

Most economists expect the Fed's moves to be enough to keep the economy growing this year, though perhaps only by 2 percent after inflation, according to a survey of 27 members of the National Association for Business Economics. That's not fast enough to prevent unemployment from growing further.

Moreover, even as it coaxes the economy to grow, the Fed must navigate several uncertainties.

A major one is productivity.

Workers' hourly output fell 0.1 percent in the first quarter of this year, as the economy slowed, driving up labor costs and fueling concern about inflation.

"Productivity was the key reason for the strong economy in the latter half of the 1990s," says Mr. Baily, now at the Institute for International Economics in Washington. "If the trend of productivity fundamentally slows, then we are in danger of higher unemployment and higher inflation."

The business economists see inflation rising to 3 percent from 2.6 percent last year.

Meanwhile, banks are tightening up their credit lines, and that could hit consumers in the next month or two, says Harald Malmgren, an economic consultant in Washington. Consumer spending accounts for two-thirds US economic output.

Then there's the global economy, where weakness in America has rippled outward.

The US slowdown has already been transmitted to the emerging economies of Asia, such as South Korea, Malaysia, and Thailand, according to the Institute of International Finance, an association of the world's largest financial institutions. It has cooled export growth, depressed stock prices, and aggravated financial imbalances left over from the 1997 financial crisis.

In turn, this Asian malaise has depressed exports of Germany.

"Germany is the sick man of Europe," Mr. Malmgren says.

European economists have been forecasting real growth in the region to remain at about 2.5 percent after inflation. The latest German statistics have put this forecast in doubt.

The European Central Bank (ECB), based in Frankfurt, had not cut interest rates since last October, despite intense pressure from the US and other industrial nations. Its primary mandate is to keep inflation under control. But faced with signs of a serious economic slowdown in Germany, the ECB finally relented.

That is a welcome but "token" step, says J. Paul Horne, an economist in London with Schroder Salomon Smith Barney Citibank, a banking conglomerate.

Dollar doubts?

But unless the situation worsens, the ECB is not expected to cut interest rates again soon.

The euro, which some see as a rival to the dollar, pepped up briefly Thursday on foreign exchange markets. But it sank back close to its low against the dollar.

One concern for the American economy is that the dollar could weaken. This would eventually stimulate exports, but would raise import prices and inflation.

If foreign investors - prompted by improving global economies - pull money out of US bonds, that would depress the dollar, raise the yield on bonds, and slow the US economy, says Michael Cosgrove, editor of the Econoclast, a Dallas-based economic newsletter.

"But as long as foreign economies remain relatively weak," he says, "the dollar is OK."

(c) Copyright 2001. The Christian Science Monitor