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Markets forcing fed to cut rates { September 2007 } Original Source Link: (May no longer be active)
http://www.bloomberg.com/apps/news?pid=20601109&sid=aEnZejdWUzMk&refer=homehttp://www.bloomberg.com/apps/news?pid=20601109&sid=aEnZejdWUzMk&refer=home
Bernanke, `Reluctant' to Cut Rates, May End Up Doing So Anyway
By Rich Miller
Oct. 29 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke and his colleagues sound as if they'd prefer to just say no to an interest-rate cut this week. The financial markets may not let them.
Policy makers from Bernanke on down have avoided signaling they want to reduce benchmark lending rates at their Oct. 30-31 meeting, ever since lowering them by a larger-than-anticipated half percentage point in September. Instead, Fed officials have stressed how uncertain the outlook is and, in words Bernanke used twice in a single week, how ``challenging'' it is to make policy.
Traders don't agree. They consider the chances of a rate cut this week as a cinch, judging from federal funds futures prices at the end of last week. If the Fed disappoints them, it risks upsetting still-fragile markets and hurting the economy.
``The Fed is reluctant to ease,'' says Louis Crandall, chief economist at Jersey City, New Jersey-based Wrightson ICAP LLC, a unit of ICAP Plc, the world's largest broker for banks and other financial institutions. ``But it also doesn't want to unsettle the financial markets unnecessarily.''
The likely rationale if the Fed cuts: a desire to prevent the worst case, in which renewed market tumult, rising oil prices and falling home values drive the U.S. economy into recession.
No Promises
The Fed, though, may combine such a move with an open-ended statement that doesn't promise further cuts. Its goal would be to dissuade investors from anticipating a series of reductions, an outlook that could further weaken the dollar and revive inflation concerns.
``They'll use the statement to try to temper expectations of further rate cuts,'' says Michael Feroli, a former Fed economist who is now with JPMorgan Chase & Co. in New York.
Speculation about what the Fed will do this week has swung widely since the central bank cut its target for the federal funds rate -- the rate banks charge each other for overnight loans -- to 4.75 percent from 5.25 percent on Sept. 18.
Traders in federal funds futures initially bet heavily on an Oct. 31 rate cut, pushing the odds of such a move to 75 percent or more at the beginning of October. They then scaled their expectations back below 50 percent after the government on Oct. 5 revised August payroll numbers to show a gain instead of a decline.
Increasing Odds
Further weakness in housing, along with dismal earnings reports from Citigroup Inc. and other big banks, helped trigger fresh market turmoil during the last two weeks, prompting traders to again raise the odds of a rate cut, with some even expecting a half-point reduction.
``The markets are yo-yoing all over the place,'' says former Fed Governor Lyle Gramley, now a senior economic adviser at Stanford Group Co. in Washington. ``The Fed ought to have a cooler head.''
Gramley is among a minority of economists who expect the Fed to stand pat. He says policy makers may not have enough evidence of a weaker economy to support another rate reduction now.
Indeed, Fed officials don't depict an economy in as dire straits as some in the markets do, suggesting they'd prefer to wait and see how conditions develop before cutting rates again.
While housing keeps weakening, the rest of the economy is holding up. Retail sales rose 0.6 percent in September, double the increase of the previous month. Business investment in computers and machinery also increased, prompting some economists to raise estimates for third-quarter growth.
Anecdotal Information
Anecdotal information the Fed has gathered from business contacts, which has more weight in uncertain times, shows the economy expanding, albeit at a slower pace than when the central bank's Federal Open Market Committee met last month.
In a regional survey known as the Beige Book, none of the 12 Fed banks reported signs of a sharp contraction in growth, based on information collected through Oct. 5.
``On balance, I would characterize the data we have received on the real economy since the last FOMC meeting as supporting our baseline forecast,'' Chicago Fed President Charles L. Evans said in an Oct. 22 speech.
That forecast calls for the economy to pick up over the next year to a growth rate closer to 2.5 percent after slowing below that level in the final quarter of this year.
Policy makers, including San Francisco Fed President Janet Yellen, have also highlighted the economy's ability to weather financial turmoil in the past as reason to avoid overreacting to the latest market squall.
The 1998 Experience
They cite 1998, when stocks slumped and credit costs rose after the collapse of hedge fund Long Term Capital Management in September. Helped by three rapid-fire rate cuts by the Fed, the economy barreled ahead, growing by 6.2 percent in the fourth quarter.
Like today, the Fed had problems managing expectations. After trimming rates a quarter percentage point in September, the central bank had to follow with similar reductions in October and November after the first cut failed to stabilize financial markets.
The Fed tried to avoid a similar situation last month with its half-point cut, says Laurence Meyer, a Fed governor from 1996 to 2002 and now vice chairman of Macroeconomic Advisers LLC of St. Louis. Instead, it once again faces calls for another cut. And traders are betting it will comply once more, if only to short-circuit a renewed increase in borrowing costs in credit markets.
Economic Risk
An economic-risk index compiled by Citigroup suggests that credit costs are rising after dropping in the aftermath of the September rate cut.
Bernanke provided the likely justification for another reduction in an Oct. 19 speech, when he discussed how to carry out policy during times of uncertainty. Rather than acting cautiously, he said then, the central bank might be better off acting boldly in response to shocks to the economy.
``That approach is motivated by the notion that the perfect should not be the enemy of the good,'' he said.
This wouldn't be the first time a Bernanke-led Fed acceded to traders' expectations. The Fed raised rates on June 29, 2006, even though some officials wondered whether the action was needed, according to minutes of the meeting. Behind the increase: rising inflation expectations in the month before, as measured by Treasury inflation-protected securities.
The Fed, though, crafted its statement at that meeting to signal its two-year rate-hiking cycle might be at an end. Inflation fears ebbed, growth slowed and the central bank didn't change rates again until it cut them this September.
Last Updated: October 28, 2007 19:08 EDT
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