Fed may cut discount rate, not fed funds rate

By Herbert Lash - Analysis

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."