Fed may need to cut rates again, analysts suggest

October 30, 2007|By Kevin G. Hall | Kevin G. Hall,McClatchy-Tribune

WASHINGTON -- Wall Street expects the Federal Reserve to cut its benchmark interest rate by another quarter-point tomorrow, but some analysts question whether that's enough.

The Fed surprised financial markets Sept. 18 by making a larger-than-expected half-point cut to its benchmark federal funds rate, the rate banks charge each other for overnight loans. It serves as the basis for a wide array of lending rates in the broader economy.

In September, the Fed set aside its worry about emerging inflation, deciding that problems in credit markets and a deepening housing slump warranted a big chop in lending rates to spark economic activity.

Since then, credit problems have eased, particularly for the short-term debt issued by profitable, sound corporations. Earnings reports by many companies have exceeded analyst expectations, and fears of a job slump appear overblown.

Normally, that would point to the Fed's policymaking body - the Federal Open Market Committee (FOMC) - doing nothing about interest rates at the end of its two-day meeting tomorrow. After all, a rate cut amid strong economic activity could reignite inflation. Oil prices are already more than $90 a barrel - itself inflationary.

So why do markets expect a rate cut?

Because the economy is projected to slow sharply over the next six months, offsetting inflationary threats. And the housing bust is becoming a bigger drag on the economy. So most analysts expect the Fed to tilt toward stimulating the slowing economy with a small quarter-point rate cut.

If that happens, it will bring the fed funds rate to 4.5 percent.

That will trigger commercial banks to cut their prime rate - the price they charge for lending to their best customers - to 4.5 percent as well.

Rate cuts lower the cost of borrowing for everything from car loans to credit-card debt, thus sparking economic activity.

Analysts aren't unanimous about what the Fed will do tomorrow, or what it should do. Some see this summer's turmoil on Wall Street as a speed bump that slowed a strong economy. Others see an end approaching for a business-cycle expansion that began in November 2001, and possible recession next year.

"We believe a 25-basis-point [quarter-percentage-point] move is more likely since many Fed officials probably continue to view the current episode as a mid-cycle slowdown rather than an all-out fight against a possible recession," said a note to investors yesterday from the economic research team of Goldman Sachs Group Inc. "In our view, however, a 50-basis-point move would be preferable because a 4.5 percent federal funds rate is still too high, given the outlook for inflation and economic growth."

The Fed will announce its decision after having seen key data before the rest of us. The FOMC will have seen third-quarter economic growth numbers, which the Commerce Department is due to release tomorrow morning. Most mainstream economists expect that the economy will have shrugged off the summer's financial turmoil and will have grown by a 3.5 percent to 3.8 percent annual rate.

That strong third-quarter growth may make the Fed reluctant to cut beyond a quarter-point, reserving the option of notching down lending rates again at the FOMC's final meeting of the year Dec. 11.

Wayne D. Angell, a veteran economic forecaster and Fed governor from 1986 to 1994, thinks that approach would be mistaken because it would add to uncertainty about the slumping dollar. The greenback has plunged against the currencies of most developed nations. Angell believes a half-point (50-basis-point) rate cut is in order now.

"If you need to be [down] 50 by the end of the year, then you ought to do 50 now. The dollar is not going to get appreciably better until the market thinks that the Fed has pretty well completed its rate reductions," said Angell.

When interest rates fall, currency traders move out of the dollar into currencies of countries where the governments pay higher interest rates to holders of government bonds and other debt.

A half-point cut could help the dollar find a bottom against other currencies and stabilize the positive trend for U.S. exports, which have become more price-competitive abroad and helped offset dollar for dollar the economic hit from the housing slowdown.

"All you do [with a quarter-point cut] is cause the dollar not to be able to stabilize," said Angell.

In weighing a half-point cut, the Fed must also consider what that might do to oil prices. Oil is mostly traded globally in dollar-denominated contracts. As the dollar declines, oil-producing nations charge higher prices to offset its loss of value. That means a half-point rate cut could push oil prices over $100 a barrel to an inflation-adjusted all-time high.

"The next big hurdle for oil is the Fed," said Phil Flynn, an energy analyst at Alaron Trading Corp. in Chicago.

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