Lending Outlook Expected to Color Fed's Rate Decision

By Neil Irwin and David Cho
Washington Post Staff Writers
Tuesday, December 11, 2007

With their interest-rate decision today, Chairman Ben S. Bernanke and his colleagues at the Federal Reserve will convey just how worried they are that banks and other financial institutions are putting the economy at risk by hoarding cash.

The Fed's policymaking committee will decide whether to lower a short-term interest rate for the third time this year. Based on prices in futures markets yesterday, investors believe there is a 68 percent chance that the Fed will cut the federal funds rate by a quarter of a percentage point, a 30 percent chance of a half-point cut and a 2 percent chance that the Fed will leave the rate at 4.5 percent.

The decision could hinge on arcane indicators that capture the degree to which banks are afraid to lend money to each other, in addition to the usual grist for economic prognostication, such as the employment outlook and inflation expectations.

The more worried the Fed is about lenders becoming unwilling to make loans, the more likely it is to make the cut a half a point to stimulate the economy and allay fears of a crisis.

The meeting will be the latest instance of the government trying to grapple with the housing and credit crises that began this summer. Today, Senate Banking Committee Chairman Christopher J. Dodd (D-Conn.) plans to introduce legislation meant to give the Fed and other bank regulators new authority to try to keep such problems from happening again.

The economy is increasingly threatened not merely by a steep downturn in housing, economists say and Fed leaders have acknowledged in recent speeches. They also worry that financial institutions that would normally lend money to consumers and businesses and help keep the economy growing are becoming fearful of massive losses from bad loans.

Instead of making the situation better, they could make it worse by offering loans only at higher cost, something that happened in November.

"Bankers and other lenders are becoming more cautious and more choosy in who they lend to," said Bruce McCain, head of investment strategy at Key Private Bank. "Every person or borrower who is priced out of the market or refused a loan is that much less stimulus to the economy."

For example, the London interbank offered rate (Libor), a short-term interest rate at which banks lend to each other, has risen sharply relative to ultra-safe government debt in recent weeks. The difference between the Libor and U.S. Treasury rates, called the Ted spread (for Treasury-eurodollar), indicates that banks are fearful of the losses they and their competitors may face and want to keep as much cash on hand as possible.

But many business loans and credit card interest rates are based on Libor, meaning that many Americans are paying higher effective interest rates than they were six weeks ago -- despite the Fed having cut the short-term interest rate it controls in an attempt to help the economy weather the housing downturn.

"The rising lending standards and higher short-term rates have effectively eliminated some of the stimulus that the Fed had in place by cutting rates at the end of October," McCain said.

One possibility is that Fed policymakers today will announce measures besides cutting the federal funds rate aimed at easing the liquidity crunch. "Central banks, including the Federal Reserve, need to give some thought to how all their liquidity facilities can remain effective when financial markets are under stress," Fed Vice Chairman Donald L. Kohn said in a recent speech.

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