Fed may cut discount rate, not fed funds rate

NEW YORK (Reuters) - A rate cut by the Federal Reserve may be in the bag, but the cut might not be the one Wall Street expects.

Wall Street has priced in at least a quarter-percentage cut to 5 percent in the federal funds rate on September 18 when Fed policy-makers are scheduled to meet.

After the government reported on Friday that U.S. non-farm jobs fell in August, futures markets suggested the Fed may even go further and cut this key rate by half a percentage point to 4.75 percent.

But some investors are bucking conventional wisdom, holding the Fed may not touch the fed funds rate out of concern that a cut could feed inflationary pressures and weaken the dollar.

Instead, Fed policy-makers might offer up more of the same medicine they did on August 17, when they surprised markets by cutting the less-used discount rate by a half-percentage point to 5.75 percent.

Banks can borrow directly from the Fed when they tap the discount rate; the federal funds rate is what banks charge each other on overnight funding. A federal funds cut has a wider impact, including consumer credit like credit cards.

Investors fear the subprime mortgage morass is seeping into the wider economy and a federal funds cut is needed to spur economic growth. But some see a discount rate cut as a better path as banks have plenty of money to lend but they are reluctant to do so, creating a credit crunch.

"If you use the discount window you target the area which is troubled," said Richard Bove, a banking analyst at Punk Ziegel & Co. "You're sending the money on a rifle-shot basis exactly where you want it."

Bove says the problem isn't liquidity, rather a crisis of confidence, which is restricting funds in selected markets.

The drumbeat for a rate cut rose steadily last week on Wall Street. Investors fear the mortgage market morass is seeping into the wider economy and an interest rate cut may be needed to spur economic growth.

That puts Fed Chairman Ben Bernanke in a tight spot. The U.S. central bank has a mandate to pursue full employment and stable prices, which suggests Bernanke would cut rates to keep the economy from tanking.

But Bernanke doesn't want to look like he's bailing investors out either.

"If people think the Fed will always bail you out then the risk-taking goes way too high, which is exactly what we've had," said Mark Coffelt, chief investment officer of Empiric Funds in Austin, Texas.

"So somewhere along the line the Fed's going to have to convince the markets if you go way out on a branch and take a lot of risk, you might just fall," he said.

A cut in the discount rate would provide the appearance that Bernanke is responding to the economy, without bending over backwards to the markets, Coffelt said.

Cutting the federal funds rate would also weaken the dollar, promote future inflation and lead investment abroad, said Bove.

"It makes it unattractive for American and foreigners to invest in the United States. I'm not sure what problem they solved" if they do that, Bove added.

If the Fed cuts the discount rate by half a percentage point, it would bring the rate in line with the federal funds rate, possibly attracting more banks to use the discount rate.

Liquidity is not at issue, but banks are keeping a tight rein on the funds they have, said Carl Kaufman, a bond manager at Osterweis Capital Management in San Francisco.

The beauty of a discount rate cut is that you're not creating a pile of new liquidity, Kaufman said. The Fed is trying to sop up the liquidity caused by cheaper lending rates in the past without killing the economy, he said.

"I don't think a Fed cut in the fed funds rate will necessarily mean that banks will have a willingness to lend at the mortgage window," Kaufman said.

"I think banks are stockpiling cash, waiting for something to happen. If nothing happens, then they'll lend."

Still, most on Wall Street argue a cut in the federal funds rate is called for. All but one of the 20 primary dealers polled by Reuters on Friday now expect the Fed to reduce the benchmark federal funds rate target on September 18.