Is the U.S. Federal Reserve Board pushing on a string? Given excess capacity in the U.S. economy, how likely is it that lower interest rates will spur increased investment as well as continued healthy levels of consumer spending? The U.S. federal funds rate was dropped a full percentage point in January, followed by fifty-basis-point reductions in March as well as in April, and yet another half-point-cut this week for a total of 250 points in five months. The stock market has been given a boost, but persistent skepticism about earnings and profits growth amongst corporate executives has delayed a resumption of vigorous capital spending. In its policy statement released this week, the Fed identified anaemic capital spending as a central concern.
Weak capital spending is complicated by the numerous transformations of the economy in the past decade. The rapid growth in technology spending as a share of overall capital expenditures reflected the advent of the Internet and rapid growth in software developments, telecommunications and, to a lesser extent, biotechnologies. Not only were new businesses being created at a vertiginous speed, but 'old economy' companies were investing to ward off new competitors and to keep abreast of new technological challenges.
By their very nature however, companies in the Internet-related sector must bear very high up-front development costs and relatively low marginal costs. They spend heavily to develop and maintain a technological lead, but it costs them very little to add a customer to their network. As long as revenues grow, they can sustain relatively high rates of capital investment and advance to profitability. However, a drop in revenues leaves them with high fixed costs and no option but to slash expenditures. Massive layoffs, dissolutions and bankruptcies are integral to this expense-reduction effort, and, until revenues resume their growth, continued cost-slashing will dominate this industry. Capital spending will be much more selective and hopefully more efficient. Optimists have characterized this situation as one of business consolidation, and point to the rapid rationalization which has transformed the Internet economy during the past year. It is reassuring to witness the end of a misguided spending binge, but, at least in the short term, interest rate reductions will do little to encourage capital investment in this sector. Consolidation must run its course.
In a similar vein, the rapid growth of Y2K-related investments may have undesired consequences for months, perhaps years, to come. Will we ever know the true cost engendered by the dire fears of a Y2K disaster? How much capital was expended for the essential tasks of ensuring that information systems were not unduly disrupted by the '00' glitch? How much was spent by over-ambitious information technology officers desperate to own the most advanced equipment and software in the business? It is estimated that US$350-billion was spent to make the world Y2K compliant. How much of this is now counted as excess capacity, unaffected by any Fed loosening?
The Federal Reserve itself caught Y2K fever and began to inject liquidity into the U.S. economy at a pace which, in hindsight, was much too rapid. The price paid was excessive tightening beginning in the spring of 2001 and the ensuing rapid slowdown in the U.S. economy. Rapid rate reductions these past months have been designed to correct the errors of the past year, and in this sense the Fed is not merely pushing a string. As confirmed by the weekly reports of the St. Louis Federal Reserve Bank, the monetary base (bank reserves and currency created by the government via the purchase of Treasury securities) has grown only modestly in recent months. Despite an upward leap in the monetary base in the last weeks, there continues to be a demand for liquidity and the Fed decision this week simply confirmed its support for continued stimulation.
Where might that stimulation be directed if capacity utilization rates remain low? First, consumer confidence must be sustained to ensure steady growth in consumer spending. In turn, demand growth should lead to improved corporate revenues, profits, earnings and eventually capital spending. Moreover corporations with healthy balance sheets enjoy an enviable opportunity to gain technological advantage during these times of adjustment, and cheaper money should encourage them to invest. Furthermore the rate of technological obsolescence may require much more rapid reinvestment in high technology than in previous economic cycles to maintain productivity growth. Excess capacity numbers may fail to take full account of these new rates of technological obsolescence. Finally, the very confidence that the Fed will support more rapid growth should encourage more risk-taking on the part of lenders, investors and innovators, allowing them to resume the process of creative destruction.
Numbers released Wednesday on consumer prices show no signs of an imminent inflationary spiral. Mixed signals on retail sales, unemployment and consumer sentiment confirm the fragility of the economy. In such an environment it is reassuring that the Fed maintains a steady hand on the monetary lever.