September 15, 2008 / 6:01 PM / 10 years ago

Fed rate cuts seen possible amid market storm

WASHINGTON (Reuters) - The Federal Reserve seems likely to stop short of lowering interest rates on Tuesday, but could signal a willingness to do so soon as it seeks to settle financial markets jolted by the bankruptcy of Lehman Brothers Holdings Inc.

People walk past the Federal Reserve building where talks were held by officials regarding the situation with investment bank Lehman Brothers in New York, September 14, 2008. REUTERS/Chip East

Through last week, markets had seen almost no chance of a rate cut at Tuesday’s policy-setting meeting. However, Lehman’s downfall further roiled already unsettled markets, and futures prices on Monday implied as much as a 92 percent chance of a cut before settling down to around 60 percent by midday.

“While we would not rule out an emergency Fed cut entirely, we think it is more likely that the Fed will use other policy tools — as it is doing — to contain the situation unless events take another turn for the worse,” analysts at Goldman Sachs wrote in a research note on Monday.

The central bank will announce its decision on interest rates at around 2:15 p.m. EDT on Tuesday.

The Fed has brought down benchmark lending costs to a low 2 percent in seven moves since mid-September 2007 through the end of April to buffer the economy from the impact of the severe housing downturn and a freezing of credit markets.

It has held rates steady at that level since then as worries grew over high inflation and a view took hold that financial markets needed extended opportunities for borrowing, not lower rates, to regain balance. If anything, the Fed had signaled until recently that its next move would likely be rate increases as markets resumed normal functioning.

SCRAMBLE FOR CASH

But after a whirlwind weekend that brought Lehman’s bankruptcy filing, news that Bank of America was taking over investment bank Merrill Lynch and a scramble by insurance giant American International Group to come up with more cash, the Fed may give a fresh look to its bluntest policy weapon to give the economy a lift.

“The 13-month-long credit crisis obviously shows no signs of waning,” said Sal Gautieri at BMO Capital Markets in Toronto.

The cost of federal funds in the U.S. interbank lending market jumped to as high as 6 percent early on Monday — well above the Fed’s 2 percent target — suggesting mistrust had grown among financial institutions. If financial firms recoil from lending to one another, the credit crisis that has helped push the U.S. economy to recession’s edge could deepen.

At the same time, a slowing U.S. economy and lower energy prices may now give the Fed room to cut rates. The economy has lost jobs for eight straight months and the jobless rate hit 6.1 percent in August, the highest level in five years.

In addition, crude oil prices have fallen by more than a third since highs hit in early July, helping to sharply lower expectations of future inflation.

“Lower commodity prices and a higher dollar have vastly improved the inflation outlook,” Gautieri said. “If the Fed doesn’t cut rates tomorrow, it will likely shift to an explicit easing bias.”

LIQUIDITY VS RATE CUTS

Fed policy-makers have attempted to distinguish between financial market considerations and macroeconomic concerns in devising their policy responses.

They have used programs aimed at boosting the smooth and liquid flow of funds to try to restore calm to credit markets, while tying interest rate cuts to concerns on the economy’s weakness.

Many analysts said the Fed had already pulled out the stops on Sunday in launching a number of new measures aimed at keeping financial markets functioning smoothly as Lehman’s affairs are wound down and that the futures market was getting ahead of itself in banking on a rate cut on Tuesday.

“The option of adjusting the funds rate per se is probably not at the top of the priority list of actions that Fed policy-makers are considering at this juncture,” said Thomas Lam Tai Loong, an economist at United Overseas Bank Group in Singapore.

Hedge fund adviser Medley Global Advisors shared that view. “Tuesday’s probably too early for an automatic monetary policy response. Highly likely that the Fed will opt for no change,” Medley said in a report, according to a source reading directly from it.

Not everyone, however, shared the view the Fed would wait for any further signs the economy was taking a turn for the worse.

“In the current environment, we think the Fed may feel the need to get in front of the situation with a more aggressive move,” David Rosenberg, chief North American economist at Merrill Lynch, told clients. “It makes perfect sense for the Fed to cut rates by 50 basis points on Tuesday and we may even see additional moves as conditions warrant.”

Additional reporting by Daniel Bases; editing by Gary Crosse

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