When does a crisis become a calamity?

CHICAGO (Reuters) - Financial markets are convinced that a Federal Reserve rate cut must come soon in order to help stem the global liquidity crisis, but many economists feel major hurdles stand in the way.

Traders work on the floor at the New York Stock Exchange, August 16, 2007. REUTERS/Brendan McDermid

The biggest open question is whether Fed policy-makers believe that the financial crisis has spread beyond Wall Street to the so-called real economy. Recent signs have been inconclusive outside of housing, where a recession already rages.

In Fed-think, what constitutes a true calamity?

St. Louis Fed President William Poole was the first policy-maker to speak since the mortgage and general credit market crisis worsened late last week.

Poole said in an interview on Wednesday with Bloomberg TV that only a “calamity” would justify an interest-rate cut now, and that “no one has called up and said the sky is falling.”

“It’s premature to say that this upset in the market is changing the course of the economy in any fundamental way,” Poole said, adding that the Fed would have to rely on some real evidence before making a move.

Marc Chandler, chief global currency strategist at Brown Brothers Harriman in New York, said: “That evidence is not just lacking, but the data over the past week or so suggests that the U.S. economy was a bit stronger than previously thought going into August.”

Short-term interest rate futures fully price a potential quarter-percentage-point cut in benchmark lending rates in September and a strong chance the Fed will cut rates by a half point at that point. Prospects for an inter-meeting rate cut are also running high.

The Fed has made four emergency rate cuts since 1994, when it adopted a policy of moving interest rates mainly at the eight Federal Open Market Committee meetings scheduled each year. Those cuts came in October 1998 and in January, April and September of 2001.

“Although severe distress in financial markets can clearly precipitate an emergency easing, the risk to the economy has always been a central focus,” Ed McKelvey, senior economist at Goldman Sachs, said in a research note.

For example, the Jan 3, 2001, cut appeared to be triggered by a drop in the Institute for Supply Management’s factory index to 43.7, deep into contraction territory and near a 10-year low.

The broad-based S&P 500 .SPX stock index had fallen about 15 percent in the four months leading up to that emergency cut, while the tech-heavy Nasdaq index .IXIC had sustained massive losses from its March 2000 peak.


McKelvey noted that the April 18, 2001, cut may have been motivated partly by an unusually long eight-week interval between the March and May FOMC meetings. “This can be an eternity when the economy is losing steam,” he said.

In that vein, the latest leg of the global credit market implosion started about 36 hours after policy-makers signed off on a fed funds rate at 5.25 percent for a tenth consecutive meeting.

And September 18 is still a long way away.

Last week’s FOMC statement said that the biggest policy concern is that inflation will fail to moderate as expected.

Credit woes aside, Fed watchers say July inflation readings so far will probably harden, not relax, the U.S. central bank’s resolve to try holding the line on rates.

“Upward pressure appears evident in the core (consumer price index) measure and that must be troubling,” said Chandler, noting that the core CPI has been rising at a 2.5 percent annualized rate over the past three months.

The year-on-year core CPI inflation trend came in at 2.2 percent for a third straight month, down from 2.7 percent as recently as February. Time will tell whether 2.2 percent is a ceiling for core CPI, or a floor.

“Over the next four months, both the headline and the core rate will rise due to base effects ... continued domestic and inflationary pressures should stay the Fed’s hand for now,” said Gabriel Stein, economist at Lombard Street Research in London.

Some analysts also worry that a rate cut would do more harm than good for the real economy -- that a rate cut could push up inflation expectations and ultimately drive up mortgage costs at a time the housing market is already on the ropes.