Rate cut to come at a cost to credibility?

By Ros Krasny -Analysis

CHICAGO (Reuters) - If the Federal Reserve steps in soon with a cut to overnight lending rates in the near future the move will likely be presented as a preemptive strike against damage to the real economy, not as a financial market bailout.

Even so, a cut in the federal funds rate target that many now expect in an attempt to deal with the worst global liquidity and credit squeeze in a decade would be a fresh test of Fed Chairman Ben Bernanke's credibility as head steward of the United States economy and inflation-fighter-in-chief.

After days of pressure from Wall Street, Bernanke got a nudge from Congress on Tuesday, after a meeting with Senate Banking Committee chairman Christopher Dodd.

"He (Dodd) emphasized that he does not want to put pressure on the Fed or interfere with FOMC policymaking, but his comments and the scheduling of the meeting itself revealed that the FOMC is facing some degree of political pressure," strategists at Barclays Bank concluded.

Losses emanating from the U.S. subprime mortgage market have hit the balance sheets of banks and funds around the world in recent weeks and created the worst credit and liquidity squeeze in world financial markets in a decade.

Last Friday the Federal Reserve cut the discount rate at which banks can borrow directly from the central bank by 0.5 percentage points to 5.75 percent. The Fed has also injected about $100 billion of extra liquidity into the banking system in its daily open market operations in the past week.

But the Fed laid the groundwork for a possible cut to the fed funds rate target, its main monetary policy tool, with a statement after last Friday's discount rate cut that staked out a new policy position from that issued following the Aug 7 FOMC meeting.

"Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward," the Fed said. "The downside risks to growth have increased appreciably."

The statement was taken by many as a shift to a bias toward a monetary policy easing that could blossom any day now.

"Their goal was to give the market a positive psychology boost to calm it, and I think they've succeeded on that front," for the moment, said Angel Mata, managing director of listed equity trading at Stifel Nicolaus Capital in Baltimore.

Fed sleuths determined that the pledge to "monitor" the situation was as good as a rate cut guarantee.

"We can find only two examples in the recent past and, in both cases, its use was an augury for inter-meeting rate cuts," Richard Iley, economist at BNP Paribas, said of the Fed's word choice. "This use of language is clearly intended to signal to markets that there is a significant chance of an inter-meeting rate reduction."

TO CUT OR NOT TO CUT ?

But the Federal Open Market Committee's best move now would be to shake off the outside pressures and wait until there is actual news on employment, inflation and growth, said Nobel prize winning economist Gary Becker.

The Fed "should refrain from any special actions until that time," Becker, economics professor at the University of Chicago, wrote on his blog.