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For Fed, It's Not Clear-Cut

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By Neil Irwin
Washington Post Staff Writer
Wednesday, January 30, 2008

Ben S. Bernanke and his colleagues at the Federal Reserve will decide today whether to cut interest rates for the second time in a week -- and find themselves in the difficult position of having either to risk cutting rates too much or risk disappointing financial markets and spurring more panic.

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The central bank cut the federal funds rate by three quarters of a percentage point a week ago, aiming to arrest a widening climate of fear in financial markets that, in the view of Fed leaders, threatened to become a self-perpetuating downward cycle that could bring the U.S. economy with it.

Financial markets calmed down after the action. But it also made the decision of what to do today, at a regularly scheduled policymaking meeting, more difficult, analysts said.

Futures markets are placing a 77 percent chance on a rate cut of half a percentage point or more. If the Fed follows through and gives financial markets what they expect, it would help stimulate a slowing U.S. economy with the steepest cutting of interest rates in a single month in the modern history of the Federal Reserve. But it also would leave the Fed with less flexibility to cut rates further if the economy gets worse. There have been some tentative signs lately that the economy is not slowing too seriously, including a report yesterday of strong sales of durable goods.

If, on the other hand, the Fed cuts rates by only a quarter percentage point or not at all, it could spook financial markets and prompt renewed worry that the central bank is not responding to the risk of a recession aggressively enough.

"The Fed is in a tough spot," said Ethan S. Harris, chief U.S. economist of Lehman Brothers. "They want to look aggressive, but it's hard to keep up with the markets, which keep pricing in even more aggressive rate cuts."

Bernanke signaled in a speech on Jan. 10 that the Fed will cut interest rates to try to prevent a U.S. recession. But at that point, despite a rapidly weakening economic picture, the central bank did not take the rare step of cutting interest rates between meetings. That changed after stock markets around the world plummeted on Jan. 21; the next morning, the Fed announced a three-quarter point rate cut, the largest since 1984.

Because of that preemptive measure, the federal funds rate, the rate at which banks lend to each other that is controlled by the Fed, is at 3.5 percent. That is less than inflation in the past year, meaning that the "real" interest rate is negative.

The Fed has never lowered the federal funds rate below 1 percent, and would be reluctant to go even that far. Many analysts expect a series of half-percentage point rate cuts at its coming meetings, which would get rates down to such a low level within a few months.

"Cutting the rate too deeply on Wednesday would leave too little ammunition for later," said Kenneth Kim, an economist at Stone & McCarthy Research Associates.

Moreover, a half-percentage point cut would further open Bernanke and the Fed to criticism that they are responding to the will of financial markets rather than doing what is needed to balance economic growth and low inflation.

The Commerce Department reported yesterday that orders for big-ticket "durable goods," or items that last at least three years, rose a strong 5.2 percent in December -- better than analysts had expected. That data series is volatile, and has been weak in recent months, but offered some solace that the economy isn't falling off a cliff. The stock market rallied on the news, with the Dow Jones industrial average up 96 points, or 0.8 percent, for the day.

If the Fed, perhaps seizing on that positive news and falling numbers of jobless claims in recent weeks, decides to cut rates by a quarter percentage point, or not at all, it risks creating a new round of cascading negative news from stock and other markets, which could necessitate deeper rate cuts in the future.

"With the fragility in market sentiment, it will be very tough for the Fed to disappoint the markets right now," said Kim, who nonetheless argues that no rate cut is called for.

Despite some modest signs of improvement in the economy, there was still more bad news in the housing sector yesterday, as Standard & Poor's reported that home prices nationally fell 7.7 percent in the year ended in November, according to the Case-Schiller index. That is the steepest drop in the 20-year history of the index.

"Home prices are in a freefall," said Patrick Newport, an economist at consulting firm Global Insight, in a report.


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