TOKYO Oct 6 The Federal Reserve could cut interest rates by a half-point this week because the central bank may want to do so at the same time as announcing changes to reserve management after winning the power to pay interest on excess reserves, Wrightson ICAP said in a research note. As part of the $700 billion bank bailout bill that passed Congress last week, the Fed can offer interest on excess reserves parked at the central bank -- an authority the central bank has long sought to help smooth intraday volatility in the fed funds rate.
Lou Crandall, chief economist at Wrightson ICAP and a well-known money market watcher on Wall Street, said that he expected the Fed to cut rates 50 basis points this month to 1.5 percent and that it may want to go ahead and pull the trigger this week. "If the Fed is ready to implement its new authority quickly, and if it expects to lower its funds target at some point this month anyway, it would probably combine the two in a single announcement," Crandall said.
Crandall noted that the effective fed funds rate has averaged 1.30 percent since Sept. 19, well below the 2 percent target USFFTARGET=, because the Fed has flooded banks with a record amount of excess funds to help relieve the near frozen conditions in money markets.
The Fed paying interest on excess reserves is expected to help put a floor under the fed funds rate and limit the end-of-day drops that have seen the effective fed funds rate plunge down to 0.670 percent late last week USONFFE=.
"It would not make much sense to introduce new structural measures that would allow the Fed to jack the effective funds rate back up to 2 percent for a few weeks if the FOMC is going to cut the target to 1.5 percent anyway," Crandall said.
Crandall said the Fed may set the rate it pays on excess reserves at 50 basis points below the fed funds target.
Fed Chairman Ben Bernanke said in a statement on Friday that the central bank would use "all powers at our disposal" to ease the credit market strains and foster a strong economy.
Even as overnight rates have been shoved lower from the massive fund injections, banks remain reluctant to lend to each other much beyond a single day, contributing to the ongoing strains driving up three-month dollar LIBOR rates USDLIBOR.
The spread between three-month LIBOR and the average expected fed funds rate in three months USDOIS surged further to a record 2.98 percentage points on Monday. Before the credit crisis erupted last August, that spread had typically been less than 10 basis points. (Reporting by Eric Burroughs)