No rate cut would spark question of what Fed knows

NEW YORK Tue Oct 30, 2007 2:07pm EDT

U.S. Federal Reserve Chairman Ben Bernanke sits before the start of the International Monetary and Financial Committee (IMFC) meeting at the IMF headquarters in Washington October 20, 2007. REUTERS/Yuri Gripas

U.S. Federal Reserve Chairman Ben Bernanke sits before the start of the International Monetary and Financial Committee (IMFC) meeting at the IMF headquarters in Washington October 20, 2007.

Credit: Reuters/Yuri Gripas

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NEW YORK (Reuters) - Federal Reserve policy-makers are widely expected to cut interest rates on Wednesday, but if they make no move, investors will wonder what the Fed knows that they don't and question its commitment to transparency.

Anticipation of a rate cut drove a two-week rally in bonds until late last week, when an upbeat outlook from Microsoft and a profit forecast from struggling mortgage lender Countrywide Financial took some steam out of U.S. Treasury bonds.

But stocks also have rallied -- at least in part -- on expectations the Fed will ease and the dollar has fallen to record lows in the last few weeks in anticipation of a cut.

At the same time, oil prices hit a record high on Monday, and if the October jobs report at the end of the week shows a strong labor market, economists say a rate cut would fan inflation worries. On the other hand, some are concerned that a cut in rates would unfairly bail out investors who have been hurt by the troubles in the subprime mortgage market.

Short-term U.S. interest rate futures on Tuesday showed a 94 percent chance the Fed will cut rates this week against 98 percent on Monday.

"If the Fed does not cut interest rates our speculation will be that the Friday unemployment report will be at the very least firm and that does risk a rise in interest rates across the board," said Jane Caron, chief economic strategist at Dwight Asset Management Co in Burlington, Vermont.

Stocks would likely immediately sell off on no Fed move and short-term bond prices would likely fall, Caron said. What longer-term bonds would do is harder to tell and would depend on the post-meeting statement.

If the Fed leaves policy unchanged, Caron said, policy-makers are likely to say they are carefully monitoring the economy and are prepared to act. But a rate cut and suggestions of more to come would push long-term bond prices down on inflation worries, she said.

The Fed has a "very difficult call" to make, but a cut will again raise the question of whether the Fed is taking risk out of the investment equation, Caron added. If it does not ease, "there's going to be a lot of criticism about a lack of transparency."

ECONOMY OR MARKETS

The Fed's mandate is the keep inflation in check and the economy growing. That makes unemployment and jobs creation key to understanding a policy decision, said John Davidson, chief executive of ParnerRe in Greenwich, Connecticut.

"If they don't do it, I think it will be because they think the economy is strong enough, it doesn't need further cuts," Davidson said. "If they do it, they do it based on continued weakness in housing and some initial signs of some weakness in employment, associated with the initial jobless claims."

Davidson agrees with the consensus view that the Fed will cut the fed funds rate by one-quarter of percentage point. The next likelihood would be no move at all because the Fed should not bail out investors who are imprudent, he said.

"I do think that the Fed is there to bail out the overall economy so that the penalties that should be absorbed by those who took out too much risk do not extend beyond the risk takers," Davidson said.

The Fed's half-point cut in September has spurred record high oil prices and pushed the dollar down -- about 3 percent -- which points against a rate cut on Wednesday, said Joseph Battipaglia, market strategist at Stifel Nicolaus.

"Since the massive intervention by the Fed, the credit markets have been recovering, though they are not fully recovered," he said. "On the economic front we still have a 3 percent growth rate, low unemployment and a pricing environment that doesn't show a lot of slack."

Battipaglia said that in the past 30 days "there seems to be less Fed speak and demands from Congress about what the Fed can do to stop a meltdown in the economy, which suggests they can take a much more measured look."

The tumbling dollar and surging oil may lead policy-makers to sit tight, said John Hardy, market strategist at Denmark's Saxo Bank. But the Fed also must avoid disappointing market expectations by not cutting, he said in a research note.

"So perhaps the highest odds scenario is that the Fed does cut, but injects firm, hawkish language that gives the Fed maximum flexibility going forward," Hardy said.

(Additional reporting by Jennifer Coogan)

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