Fed Decision on Key Rate Presents Risks Either Way

The Federal Reserve will decide today whether to cut interest rates for the seventh time in seven months. For leaders of the central bank, there is no obvious course of action, with big risks no matter what they do.

The policymakers' most likely course is to cut the federal funds rate by a quarter percentage point, to 2 percent, according to the consensus of Fed watchers. In this view, the central bank would signal, through its statement accompanying the rate cut, that it was inclined to hold off cutting rates any further if there are no new negative surprises for the economy or financial markets.

"There are still enough problems out there for them to be concerned about the risks to growth," said Peter Hooper, chief economist of Deutsche Bank Securities. "The odds aren't overwhelming, but they favor cutting further."

That action could end up mirroring what the central bank did in late October, when financial markets seemed to be healing. It cut interest rates a quarter percentage point, and said in a statement that the risks to growth and inflation were "roughly balanced," meaning that it would be disinclined to cut again.

In the view of some observers, the October move hurt the Fed's credibility when financial markets worsened again in the ensuing weeks and it ended up cutting rates at its next meeting after all. "Anytime you draw a line in the sand, there's a risk that ultimately something will arise that washes away that line," said Kenneth Kim, an economist with Stone & McCarthy Research Associates.

That is one reason there is also a significant chance that the Fed might defy the conventional wisdom by not cutting rates but signal that it is ready to resume rate cuts if the economy or financial-market conditions get much worse. Options markets yesterday assigned a 27 percent chance for such a pause.

Fed leaders don't want to cut rates much more. A pause would demonstrate their resolve in fighting inflation and give them time to assess how much the previous rate cuts and fiscal stimulus will help the economy in the second half of the year.

This is the first time since October that the Fed's policymaking committee has met during a period of comparative calm in financial markets, as a wide range of markets for debt have been functioning more smoothly in recent weeks. The relative calm on Wall Street -- the stock market is up more than 8 percent this month, and a variety of more obscure indicators show some measure of healing -- lowers the risk that a decision not to cut rates would cause a new round of distress in financial markets.

Also offering the Fed some wiggle room: At its March meeting, Fed policymakers disappointed financial markets a bit by cutting rates by three quarters of a percentage point, not the full point that many had expected. Yet no big problems resulted, even though that was a more fragile time on financial markets compared with the present.

Not cutting now would also save room for future interest rate cuts if there is a new leg down for the economy and financial markets. And it might satiate presidents of several regional banks in the Federal Reserve system, who have given speeches indicating concern about inflation and have dissented with past interest-rate cuts.

Martin S. Feldstein, a leading economist who argued as early as last summer that the U.S. economy was at grave risk and that the Fed should respond aggressively, changed his tune recently and argued for not cutting rates.

"It's time for the Federal Reserve to stop reducing the federal funds rate," Feldstein said in an opinion article in the Wall Street Journal this month, "because the likely benefit is small compared to the potential damage." He cited worries about inflation, and evidence that rate cuts are not flowing through to those who take out mortgages and other types of loans.

If the Fed were to ignore expectations and leave rates steady today, the decision would carry with it risks of its own. It might lead financial markets to conclude that the central bank was becoming complacent about the slowing economy, for example.

"The economy never travels in a nice straight linear path," said Kim. "With all the weak economic data we're getting and the pressure on the financial system, I still believe that this housing crisis won't dissipate anytime soon, which keeps pressure on them to stimulate the economy."