washingtonpost.com
Waiting On Fed To Make A Move
Wall Street Expects Rate Cut; Central Bank Not Certain

By Neil Irwin
Washington Post Staff Writer
Thursday, October 2, 2008

Wall Street overwhelmingly expects the Federal Reserve to cut interest rates quickly and sharply to boost the economy. But for leaders of the Fed, it is still more of an open question.

For weeks, traders in financial markets have talked of a surprise interest rate cut any day, a move that would be designed to help the stumbling economy and confidence-drained financial markets. Market participants view it as a near-certainty that the Fed will make such a move by the end of its policymaking meeting Oct. 28-29, based on prices in futures markets.

Such a move is a strong possibility. But the Fed is inclined to wait for more-solid evidence that the economy is dramatically deteriorating before cutting the federal funds rate below its current 2 percent level. Fed leaders also believe that conditions in credit markets are so frazzled now that it is hard to predict whether a rate cut would have its desired impact of stimulating the economy.

"A rate cut in the future will be based on economic weakness that exceeds what they had already built in," said Julia Coronado, a senior U.S. economist at Barclays Capital. "There's a good chance we'll see that weakness, but they want the data to be there before they cut rates."

There are plenty of signs that the economy is getting worse. Just yesterday, the Institute for Supply Management said that its index of manufacturing activity fell sharply, indicating that what has been a mild contraction in the nation's factories is becoming a major one. Friday, the Labor Department will report on September job market conditions, a reading that economists expect will be miserable.

More weak data could help the members of the policymaking Federal Open Market Committee coalesce around a rate-cut plan in the weeks ahead. Just yesterday, Charles I. Plosser, president of the Philadelphia Fed and a member of that committee who has been averse to rate cuts at times this year, indicated openness to them if conditions keep worsening.

As the crisis deepened in September, the Fed has lowered its expectations for economic growth. Its leaders also believe there is a much higher probability than there was a few months ago of a situation in which a broad contraction in credit fuels a deep and prolonged recession.

"When worried lenders tighten credit, then spending, production, and job creation slow," said Fed Chairman Ben S. Bernanke in congressional testimony last week. Recently, he said, "economic activity appears to have decelerated broadly."

Interest rate cuts spur economic growth by making it cheaper for consumers and businesses to borrow money, among other ways. But with banks struggling, they may not pass through the benefits of a rate cut to their borrowers.

"When credit channels are frozen, monetary policy has less effect," said Peter Hooper, chief economist of Deutsche Bank Securities. "The hope would be that a rate cut would have an impact on confidence, and then that when credit channels do start working again, the economy will benefit."

Moreover a rate cut could have hard-to-predict impacts on the value of the dollar and oil and other commodities. It could cause the value of the dollar to fall and the price of oil to rise. It could make imports more expensive, while not stimulating growth.

One popular prediction among Wall Street insiders has been that the Fed would undertake a surprise rate cut, perhaps coordinated with other central banks, to try to help financial markets and the economy escape their doldrums.

Bernanke has generally been inclined to wait until regularly scheduled meetings to make interest rate moves, holding the view that surprise interest rate cuts can unsettle markets by putting them on edge waiting for a potential Fed action every time markets seem troubled. He made an exception to that policy only once, with a surprise interest rate cut in January, but then there was already wide consensus among Fed leaders that major rate cuts were needed.

Also the Fed so far has wanted to focus on measures that directly attack the source of the crisis, which is unwillingness of financial institutions to lend. So Bernanke has supported the Bush administration's proposed bailout package, taken over insurance firm AIG, and expanded programs to inject cash into banks.

"It's natural for market participants to assume the Fed will come in, but the Fed is doing other things to try to address the situation," Coronado said.

Finally, the European Central Bank, which would be the key ally in any coordinated rate cut, is in a different spot than the Fed. The leaders of the ECB are still deeply worried about inflation, making them disinclined to cut rates soon.

View all comments that have been posted about this article.

© 2008 The Washington Post Company