Fed likely to cut funds rate to the bone

By Ros Krasny

CHICAGO (Reuters) - The Federal Reserve seems almost guaranteed to wade into unchartered waters in December and cut its benchmark lending rate below 1.0 percent.

Unrelenting bad news on the U.S. economy, reflected most recently in minutes from the Federal Open Market Committee's October policy meeting issued on Wednesday, suggest another interest rate cut is in the works, even as rates approach the so-called "zero bound."

"Some members were already feeling that additional policy easing could be appropriate ... given recent data and developments in financial markets, 'some' may have turned into 'most," said Rudy Narvas, analyst at 4CAST Ltd in New York.

Short-term interest rate futures fully price a cut in the fed funds rate to 0.5 percent from 1.0 percent at or before the Dec 16 policy meeting.

The effective fed funds rate averaged 0.63 percent in May 1958, the lowest level shown by Federal Reserve Board records dating back to 1954.

The FOMC cut the rate to 1.0 percent in October, the latest move in an easing cycle that started in September 2007, when the funds rate was 5.25 percent, as the central bank attempts to pump life into the U.S. economy.

Sky-high futures prices also reflect ideas that the cash funds rate will continue to trade below the target rate. Cash fed funds last traded at 0.3125 percent.

Although some policy-makers have noted technical problems in cutting the target rate below 1.0 percent, opposition could melt away in the face of current economic reality.

"The economy has basically imploded," said Mark Lane, an analyst with William Blair and Co in Chicago. "Consumer confidence is at an all-time-low, risk tolerance is at an all time low, and corporate credit spreads are at all time highs."

Wednesday's FOMC release included updated forecasts, assembled at the Oct 28-29 meeting, that pointed to a long if not necessarily deep economic recession.

"While some expected an improving financial situation to contribute to a recovery in growth in mid-2009, others judged that the period of economic weakness could persist for some time," the Fed said.

The Fed lowered its "central tendency" forecast range for 2008 gross domestic product growth to between zero and 0.3 percent from June's 1.0 to 1.6 percent. Some at the FOMC said the economy could shrink by 1.0 percent in 2009 with the jobless rate as high as 8.0 percent versus the current 6.5 percent.

Even those assessments, cobbled together in the final days of October, might need to be lowered given the recent labor market deterioration that will only feed the vicious cycle of negativity.

In response, U.S. stock markets were pushed to the brink. The Dow Jones industrial average shed another 5.0 percent and closed below 8,000 points for the first time since 2003.

KOHN -- LEARN FROM JAPAN