Fed faces day of reckoning as markets clamour for rate cut

WASHINGTON : Federal Reserve policymakers face a moment of truth Tuesday as they meet on interest rates amid a sputtering economy, but with some arguing against a return to easy-money conditions blamed for the problems.
The Federal Open Market Committee, set to announce a decision at 1815 GMT Tuesday, is widely expected to cut interest rates in a bid to ease stress in the housing and credit markets, and head off a potential recession.
Most analysts say they expect the FOMC, which has held its federal funds rate at 5.25 percent since June 2006, to cut the benchmark rate by 25 or 50 basis points, which could lead to lower borrowing costs for many consumers and businesses.
A rate cut "would reflect an effort to contain the downside risks to growth associated with the swift tightening in financial conditions this summer in an already subpar economy," said Citigroup economist Robert
DiClemente, who predicts a half-point cut. DiClemente says the current rate of 5.25 percent is "higher than neutral," or holding back economic growth, and that a failure to cut rates "could risk an undesirable breach in investor confidence and broader damage to the expansion."
"The sooner we get to 4.5 percent or thereabouts, the better the chances of stabilising the economic outlook and the financial system that supports it," DiClemente said.
Some analysts say that if the Fed fails to take bold action such as a half-point cut, it could trigger more turmoil in financial markets, causing more failures of home lenders and mortgage defaults and prompting a freezing up of broader credit markets.
"We strongly believe that if the Fed only cuts rates by 25 basis points even with a strongly worded FOMC statement to commit to more easing if need be, there could be a significant disappointment trade in the financial markets, especially in stocks," said Deutsche Bank economists Joseph LaVorgna and Carl Riccadonna in a note to clients.
"If policymakers move too slowly now, they run the risk that more considerable damage will be inflicted on the financial markets and the real economy, and resultantly they will have to cut rates more aggressively in the long run."
Others claim that economic conditions do not warrant a rate cut, and that such a move would simply be providing more of the easy money that fuelled the boom-and-bust cycle.
"The US economy is not booming...However, the economy is not collapsing either," argued Eugenio Aleman, senior economist at Wells Fargo, who says it would be wrong for the Fed to buckle to market pressure.
"A fed funds cut will not bring back the US housing market. A fed funds cut will not bring back the commercial paper market," he said.
Aleman said the Fed must consider what happens if it cuts rates and the housing market remains depressed:
"Then the markets will ask for another rate cut, and another, and another, and another - and then what?" he said.
"The fact of the matter is that the sub-prime mess was a bad investment decision from the very beginning and was brought about by having very low interest rates for a very long period of time. And the only way to go forward is to flush it out, take the loss and move forward, not bring it back."
Brian Wesbury at First Trust Portfolios agreed, saying: "We still hold out hope the Fed will do the right thing, which is not cut rates at all. Cutting rates, when they are already too low, will 'lock in' inflation, force more rate hikes later, and puts the Fed's credibility as an inflation fighter at risk."
The US economy expanded at a robust 4.0 percent pace in the second quarter, but many experts view that as a statistical fluke that belies soft conditions.
The loss of 4,000 jobs in August, say some, point to deep problems as the housing slump and credit problems drag on growth.
Of key importance is the message sent to financial markets.
Chairman Ben Bernanke wants to ease economic stress while avoiding the impression that he is bailing out speculators and hedge funds.
"The decision to cut interest rates by 25 or 50 basis points will not be nearly as important as the Fed's language," said Nick Raich, analyst at financial group National City.
"We believe market bulls will need a Fed that will show it is willing to do whatever it takes to prevent the economy from slipping into a recession." - AFP/ch

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