Copyright © 2001 by Norman P. Poire. All rights reserved.

Five discount rate cuts in 133 days. That is the way history will record it if a chorus of concerned economists, smarting investors, and nervous workers has its way.

The Federal Reserve Board has been roundly criticized for not moving fast enough — for being "behind the curve" — in shoring up a sagging economy, particularly in the manufacturing sector. However, with four rate lowerings to his credit already and another likely at the May 15 FOMC meeting, a Fed chairman known for measured responses to changing economic conditions is now officially a rate-cut heavyweight.

The reining champion in this category is the 1970-71 Fed who dropped the discount rate five times in just 99 days. Fed chairman Alan Greenspan can secure the number two spot by trimming rates again next month. In so doing, he will beat out the current second place titleholder, the 1974-75 Fed, by 26 days.

In its entire 88 year history there have been only five occasions when the New York Federal Reserve pulled the discount rate trigger a fifth consecutive time in less than a year. Aside from the two swiftest already mentioned the remaining three in order of shortest to longest duration are 1921-22, 1929-30, and 1981-82.

While it might seem obvious that the more interest rate cuts the merrier for both the economy and the stock market, history has a different take on the matter.

In all five rate-cut cycles cited, the U.S. economy found itself in recession. These were not just any recessions — they include the four most severe contractions since World War 1. The average unemployment rate for the five recessions was nearly 13 percent. According to statistics published by the National Bureau of Economic Research (NBER), the average duration of these contractions was 21 months.

Granted the statistics are skewed by the Mother of All Recessions, the Great Depression of the 1930s. Excluding that calamity still leaves a dismal unemployment rate of more than 9 percent and duration of 15 months.

In recent years the level of unemployment has increased proportionately with the number of interest rate reductions, regardless of the elapsed time between cuts. Since 1970 there have been five instances where the Fed lowered interest rates five or more consecutive times. The chart below clearly shows the direct correlation between rate reductions and economic pain — the more cuts the greater the pain.

It would be silly to suggest, of course, that the Fed cuts are a cause of the recession or that we would be better off with fewer rather than more interest rate reductions. What I am suggesting is that history tells us to treat the kind of aggressive action we are witnessing by the Fed very seriously. There is likely an ominous reason why the Greenspan Fed sees fit to move as quickly as it has.

The accompanying charts below demonstrate a link between the U.S. unemployment rate and an indicator that is based on the difference between the three-month U.S. Treasury yield and the stock dividend yield on the S&P 500 Composite Index.

I call this indicator the Slump Index. It is an oscillator that is constructed by subtracting the interest rate difference from its own twelve-month moving average. When the oscillator drops below -1, the economy as measured by the unemployment rate is usually showing signs of recession. As the index crosses above -1, the economy is on its way back to prosperity. It has predicted all five official recessions since 1970 with just a single misfire in 1984-85 when it gave a false positive reading.

The reason it works so well is easy to understand. As the economy slows, nervous consumers reduce their borrowings and increase their savings. The decreased demand and increased supply of money has a depressing effect on short-term interest rates. Meanwhile, share prices fall due to poor earnings forecasts, thereby raising stock dividend yields. The difference between falling three-month treasury yields and rising dividend yields can eventually move into negative territory, triggering a recession signal in the model.

What the Slump Index is telling us right now is that with dividend yields at current levels, U.S. Treasury bill yields are low enough to signal an important downturn in the economy. With an 83 percent confidence level, the model is indicating that we are already in recession and that is why the Fed is reacting so aggressively.

There are only two events that could turn the Slump Index positive and signal that the worst is over. The obvious remedy would be for the Fed to raise short-term interest rates. That doesn’t appear likely with the economy still sinking into the doldrums.

Failing that, the S&P 500 Composite Index would have to soar to around 1600 to push the index above the -1 level with short-term rates as they are, much higher if rates fall further. While sharply rising share prices can’t be ruled out, our stock market model suggests that stocks can only move higher if the long bond remains well behaved. A move by the 30-year Treasury much above 6.00% would likely trigger a new round of selling that would take the markets below their recent lows — perhaps far below.

More than likely we will have to wait for the Fed to signal that the economy is finding its legs by increases in the discount and federal funds rates. That won’t happen until they are convinced that the rate cuts have done their job.

So just how effective have aggressive rate reductions been in undoing past recessions? In three of the five most aggressive rate-cut cycles, the economy found bottom before the fifth discount rate reduction was in place. In a fourth the low point showed up three months after rate cut five.

The good news ends there. The one time rate cuts didn’t bring economic relief was following the Crash of 1929. That crash came on the heels of one of the great capital investment booms in history. The ensuing Great Depression unleashed its wrath for 34 months beyond the fifth lowering of the discount rate.

As the Japanese are discovering, capital investment booms are followed by capital investment busts that are notoriously resistant to interest rate reductions. Here in the U.S. we find ourselves letting the air out of a most impressive capital investment boom of our own.

There is no reason to believe that our economy today will suffer the 1930s all over again. That economy was saddled with suffocating tax, trade, and wage policies that are not on the radar screen today. But we will not unwind excess capital investment overnight. It will also take time for households to rebuild the personal savings rate while at the same time servicing near-record debt.

Much like the economy, the stock market presents a mixed picture vis-à-vis aggressive rate cuts. In all five instances stocks found at least an intermediate bottom before the fifth lowering of the discount rate. But only twice did these reductions mark long-term bottoms — in 1921 and 1982.

After the 1929 Crash, discount rate cuts helped revive stocks with a 50 percent retracement of that historic decline. Ultimately, however, they failed as the most famous bear market in U.S. history drove share prices much lower over the next 26 months.

In 1970 and again in 1974 Fed rate cuts reversed cyclical bear markets. However, on an inflation-adjusted basis, stocks fell for over 14 years from December 1968 to August 1982, making this period the longest running secular bear market of the century.

Wishing for further cuts in the discount rate to avoid recession or to prop up share values ignores the lessons of history. In the past, more was not better for either the economy or for stocks. On the contrary, continued aggressiveness by the Fed should raise a caution flag that serious trouble lies ahead.

Posted April 2001

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