Rate cut to come at a cost to credibility?

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.

Arguably, though, given the deteriorating state of the credit market, "policy makers do not have the luxury of waiting for clear evidence of an economic effect," said Chris Low, chief economist at FTN Financial in New York.

The volatility index, or VIX, known as Wall Street's "fear gauge," is down about 33 percent from a high registered at the nadir of the stock market on Thursday.

The calm may reflect an acceptance that the Fed will indeed cut rates soon, perhaps after waiting out the wildest market swings as it has done when making some of its rare inter-meeting rate moves in the past.

Short-term rate futures, which measure expectations for Fed policy, show a strong chance the Fed will cut rates 50 basis points on September 18 or before from the current 5.25 percent.

Still, a massive shift into U.S. Treasury bills, the safest of safe-haven instruments, in recent days shows that investors are still looking for shelter and might not be satisfied with anything short of a rate cut.

MORAL HAZARD

A preemptive Fed move would plunge Bernanke waist-deep in a "moral hazard" morass: the sense that the Bernanke Fed, like its predecessors, will step in to bail out financial dealers who have badly overreached on the greed-vs-fear scale.

Some suspect that the chairman would prefer more of a "tough love" approach, leaving the credit markets to sort out their own mess.

"Hedge funds or other lenders that may be in financial difficulties because they excessively invested in assets of dubious value ... should bear the consequences of their mistakes," Becker said.

Marc Chandler, global head of currency strategy at Brown Brothers Harriman, said a September rate cut is still not a done deal, and that the creation of a "Bernanke put" is still in the balance.

"The market is not sure that Bernanke still adheres to what Greenspan and he previously articulated," Chandler said.

"We suspect Bernanke does in fact want to distance himself from it, but that the turmoil in the markets is making it difficult to jettison it completely."