Credit crunch may spook Fed into going big again

By Pedro Nicolaci da Costa

NEW YORK (Reuters) - Wall Street is counting on a Halloween treat from a U.S. central bank that looks set to lower interest rates next week, but the Fed might just double the sweetness with another surprisingly large cut.

Admittedly not the predominant view on Wall Street, it has nonetheless gained some ground following news this week that the U.S. housing slump, already the most severe in more than a decade, had taken another turn for the worse.

Respectable consumer spending and upward revisions to employment earlier this month had convinced analysts the Federal Reserve could afford to pause at its October 30-31 meeting, having chopped the benchmark fed funds rate by a half point to 4.75 percent in September.

Since then, a deepening of the housing downturn, including a startling drop in home values, has put a modest quarter point decrease back on the market's radar. Nonetheless, the vast majority of investors have stopped short of forecasting another 50 basis point cut.

Yet a closer look at the reasoning behind the surprisingly robust reduction in rates at its last meeting, as well as developments since, suggests the Fed may opt for an encore. Last time around, it is worth remembering, very few expected the bolder cut that came to pass.

"We're entering a period of speculation of whether the Fed will go 25 or 50" basis points, said Steve Malyon, currency strategist at Scotia Capital in Toronto.

For one thing, policy-makers specifically stated in their last communique that the aggressive cut had been preemptive, an effort to keep tighter credit conditions from hanging around long enough to crimp an already faltering economy.

With this in mind, what semblance of order has returned to business lending could well be predicated on a broader stance of monetary easing from the Fed, not just a one-off cut.

The mere fact that the housing recession appears to have deepened following the summer's credit crunch suggests the much-feared effects of tighter lending on growth are already being felt.

Moreover, in the context of Merrill Lynch's huge loss for the third quarter and growing fears that the full effects of the financial crisis have yet to be fully felt by banks, normalcy has become a relative term.

Officials have also indicated they would be worried by any substantial decline in home prices, which on latest count seem to have accelerated.

Fed Board Governor Frederic Mishkin, discussing the issue at Jackson Hole earlier this year, reiterated the Fed cannot and should not target asset bubbles as they appear to be inflating. But he added officials might do well to cushion the fall.

"A prudent central banker would be better advised to deal with adverse macroeconomic consequences as they emerge in the wake of any substantial decline in asset prices," Mishkin said.

Even the Fed Chairman himself has offered some hints, both recently and in the past, that he would not be wholly averse to a bolder policy easing.

In a 2003 speech as Fed Board Governor, Bernanke highlighted evidence that looser monetary policy that took markets by surprise have beneficial effects on asset prices. "Each basis point of surprise monetary easing leads to about a 5-basis-point increase in the value of stocks."

Of course, the asset in trouble this time is housing, not equities. But even by Bernanke's own admission, that only strengthens the case for swift action.

In a speech this month that avoided grappling with current policy directly, Bernanke dropped a couple of clues that dovish-leaning analysts have seized upon.

"Intuition suggests that stronger action by the central bank may be warranted to prevent particularly costly outcomes," he said.

Those calling for a larger move believe the self-reinforcing double-whammys of housing and credit are just too much for the Fed to ignore.

"We still think the Fed lowers 50," says Andrew Brenner, market analyst at MF Global.

Treasury bill rates support that case.

"The Fed always follows the 90-day Treasury bill," said Drew Kanaly, chairman of Kanaly Trust Company in Houston, noting three-month bill rates, at 3.82 percent, are nearly a full percentage point below the current target rate.

"They've got 80 basis points they can go," Kanaly said. "We know they can do it. It's rare that fed funds and the 90-day T-bill are that far apart."

(Additional reporting by Ros Krasny in Chicago and Lucia Mutikani and Jennifer Coogan in New York)