Fed May Cut Interest Rates, Leave Door Open for Further Action

The Federal Reserve will probably cut interest rates today and lay the ground for more to prevent the economy from sliding into recession.

The Federal Open Market Committee will be loath to repeat language from its last meeting that risks between inflation and growth are roughly balanced, economists said. Keeping the phrase would open officials to criticism they're oblivious to the credit squeeze that's threatening growth.

They pretty much tried to draw a line in the sand by going to a balanced-risks statement at the last meeting, and now the world's changed, said Keith Hembre, who used to work at the Fed and is now chief economist in Minneapolis at FAF Advisors Inc., which manages $105 billion. Officials will leave themselves the opening for further cuts, he said.

Chairman Ben S. Bernanke is trying to steer through the housing recession that entered its third year and alleviate a jump in borrowing costs for companies and consumers. The FOMC will lower the benchmark rate by a quarter point to 4.25 percent, according to 113 of 123 economists surveyed by Bloomberg News. Seven anticipate a half-point move and three see no change.

Officials may also enhance their efforts at providing a backstop for bank funding amid a surge in demand for cash, some economists said. Options include reducing the charge for direct loans to banks by half a point, to 4.5 percent.

Most Since Recession

The Fed is scheduled to announce its decision at about 2:15 p.m. in Washington. A quarter point rate cut, after 0.75 percentage point of reductions in September and October, would mark the greatest easing of borrowing costs since the last recession in 2001.

Bernanke and Vice Chairman Donald Kohn recognized in speeches last month a deterioration in credit markets that jeopardizes lending to businesses and consumers, threatening spending. That was a shift from the Oct. 31 statement, when officials signaled they were reluctant to do more.

The reality is, markets have gotten worse in a way they couldn't have expected, and they've gotten worse to a point where there are legitimate concerns that it will spill over to the macroeconomy, said Vincent Reinhart, who was Bernanke's chief staff adviser on monetary policy before leaving in September to join the American Enterprise Institute in Washington. Not acting would be too much of a surprise.

Traders estimate a 26 percent chance of a half-point reduction today, with a quarter-point fully discounted, according to futures prices quoted on the Chicago Board of Trade.

Recession Calls

Economists including former Treasury Secretary Lawrence Summers and the chief U.S. economists of Morgan Stanley and Merrill Lynch & Co. predicted a recession in the past month as strains in credit markets increased.

The collapse of the U.S. subprime mortgage market has led Citigroup Inc., Merrill and other banks and securities firms around the world to write down about $76 billion of losses and markdowns this year.

Concern about the mounting losses diminished banks' willingness to lend cash to each other, sending funding costs higher. The three-month dollar London Interbank Offered Rate climbed to as high as 65 basis points more than the Fed's benchmark rate last week. That's the widest spread, except for on Sept. 18 when the Fed cut rates, in seven years.

Yields on two-year Treasury notes dropped as low as 2.79 percent on Dec. 4, the lowest since November 2004, as investors flocked to the perceived safety of government debt.

Demand for Cash

The scarcity of cash comes at a time when banks typically conserve funds to buttress balance sheets before closing their books for the year.

The Fed's New York branch said Nov. 26 it planned a series of repurchase agreements extending into 2008 to help fill cash shortages. Stephen Cecchetti, a former New York Fed research chief, said officials may consider further steps, such as extending discount-rate loan terms to 90 days, from 30. The outstanding loans rose to the highest since September last week.

If I backed myself into this position, I would grit my teeth and just cut, big time, said Cecchetti, who is now a professor at Brandeis University in Waltham, Massachusetts.

Some Fed officials indicated heightened concern inflation would quicken, before Bernanke and Kohn spoke two weeks ago. Philadelphia Fed President Charles Plosser said Nov. 27 that price expectations may increase because of the rate cuts.

Source - Bloomberg