Three Telling Days for the U.S. Economy

There wasn't much activity to monitor as stocks were lightly traded on eve of Fed's decision on interest rates.
There wasn't much activity to monitor as stocks were lightly traded on eve of Fed's decision on interest rates. (By Richard Drew -- Associated Press)
By Neil Irwin
Washington Post Staff Writer
Tuesday, September 18, 2007

Today, Wednesday and Thursday are shaping up to be pivotal days for financial markets' recovery from disarray and for the direction of the U.S. economy.

The much-anticipated announcement of whether, and by how much, the Federal Reserve will cut a key interest rate is to come at 2:15 p.m. today. During the week, earnings reports from four major investment banks will give a sense of how badly Wall Street has been hit by the credit crunch: Lehman Brothers (today), Morgan Stanley (Wednesday), and Bear Stearns and Goldman Sachs (Thursday).

More clues to what's coming -- from the Fed and from Capitol Hill -- may emerge when Fed Chairman Ben S. Bernanke and Treasury Secretary Henry M. Paulson Jr. testify before a House committee Thursday. And important data about inflation come out today and Wednesday.

These developments could help stabilize markets and prevent their troubles from spreading further through the economy, or they could create new tumult.

"If there are no big surprises this week, then I think we will see the volatility in the financial markets go down," said Howard Chernick, an economics professor at Hunter College in New York. "That doesn't mean that the stock market will necessarily go up. That depends on what happens to the economy. But these wild swings will decrease."

Here are seven questions that will be answered, at least in part, over the coming three days:

How worried is the Fed? The Fed's policymaking committee has a target for the federal funds rate, the interest rate that banks charge each other for overnight loans, of 5.25 percent. That rate ultimately affects the cost of borrowing money by businesses and consumers through credit card interest rates, commercial loans and more. Pricing in yesterday's futures markets indicated that investors see a 51 percent chance that the Federal Open Market Committee will cut that rate a quarter of a percentage point, to 5 percent; a 41 percent chance of a half-point rate cut, to 4.75 percent; and a 6 percent chance that rates will be cut to 4.5 percent. The bigger the cut, the greater the Fed's concern that the economy is slowing and in need of stimulus. A cut of 0.25 percentage points would be a sign that Bernanke and Co. are reasonably confident about the economy.

Will the Fed continue to try unconventional tactics? In August, when problems in financial markets became serious, the Fed chose not to lower the federal funds rate, which would have directly stimulated the economy. Instead, it cut the discount rate, a little-used rate charged to banks, in an effort to keep money flowing through the financial system. It was an attempt to carefully match the central bank's solution to the problem at hand, and it received positive reviews. This week, some economists say Fed policymakers could decide to drop the discount rate by a further half-point and the funds rate by a quarter-point instead of following the usual policy of moving them together. That would represent an unconventional middle ground, showing the Fed's willingness to use the tools available in creative ways.

Is there still a Greenspan effect? Alan Greenspan has been in retirement for almost 20 months, but Bernanke's predecessor as Fed chairman looms large this week, thanks to the publicity tour for his new autobiography. And this may make Bernanke's job easier. On "60 Minutes," Greenspan said his view of the U.S. economy is generally sound and expressed worry about inflation. That means if Bernanke cuts rates by less than Wall Street might prefer, investors might at least find some solace in the hints that Greenspan would have done the same.

How united is the Bernanke Fed? If today's policy announcement shows that many members dissented from the majority, it will be a sign that there are fault lines among Federal Reserve governors and regional bank presidents, who together make up the Federal Open Market Committee.

How hard has the credit crisis hit the balance sheets at big brokerage houses? Assuming that the losses are fully disclosed, investors will learn how much the value of assets on the books at Lehman, Morgan, Bear and Goldman have been marked down. If the losses are manageable, the earnings reports would open the door for financial markets to continue to stabilize. But a few nasty surprises could make markets tremor all over again.

Is inflation still a threat? The producer price index is to be released this morning, and the consumer price index on Wednesday. These numbers will indicate whether prices are rising (for businesses and households, respectively) more than policymakers are comfortable with.

"A big move on inflation would make it harder for them to cut [interest rates]," said David Wyss, chief economist at Standard & Poor's.

Can Bernanke finesse Congress? Officially, the topic of the House Financial Services Committee's hearing Thursday is mortgage foreclosures. But committee members are likely to use the occasion to tell Bernanke what they think about his stewardship of the country's monetary policy. Chairman Barney Frank (D-Mass.) has already publicly urged the Fed to cut rates.

© 2007 The Washington Post Company