September 16, 2007 / 3:40 PM / 12 years ago

Fed set to cut interest rates

CHICAGO (Reuters) - A long period of stasis in Federal Reserve monetary policy looks certain to end on Tuesday with a U.S. interest-rate cut, leaving the question of how much further rates may drop and how fast.

A Federal Open Market Committee meeting in Washington, March 28, 2006. A long period of stasis in Federal Reserve monetary policy looks certain to end on Tuesday with a U.S. interest-rate cut, leaving the question of how much further rates may drop and how fast. REUTERS/Federal Reserve/Handout

The rate-setting Federal Open Market Committee is tipped to lower its target for the overnight federal funds rate by either one-quarter or one-half percentage point from the current 5.25 percent, where it has been since June 2006.

Signs of economic trouble, capped off by a surprising drop in U.S. jobs in August, have opened the door for the Fed to deliver the rate cut so desperately wanted on Wall Street after a month of turmoil in global financial markets.

“The market is now increasingly focused on the economic fallout from the tighter credit conditions, which is tantamount to a tighter monetary policy,” said Marc Chandler, chief global currency strategist at Brown Brothers Harriman in New York.

Indeed, prospects for a return to sub-par growth after a strong second quarter have even raised the specter of recession. While economists disagree on the probability of a downturn, they agree risks have risen.

The rate cut expected on Tuesday would be the first under the leadership of Ben Bernanke, the former Princeton University economist who took over from Alan Greenspan as Fed chairman in February last year.

Some analysts think the Bernanke Fed, whose approach to policy changes seems more deliberative and model-driven than the approach taken by Greenspan, is already behind the curve.

“Events are moving rapidly in a negative direction, and the Fed needs to get out in front of them,” said Carl Tannenbaum, chief economist at LaSalle Bank in Chicago.

“Many still feel that monetary policy should not be based solely on the most likely outlook, but also influenced by the risks to that outlook.”

25 or 50?

Financial dealers are split on how aggressively the Fed will act this week, and rhetoric from policy makers has suggested they have differing views as well.

Some Fed officials have suggested dramatic action may be warranted to offer quick support to a falter economy.

Others have been more cautious, stressing the economy’s resilience and the importance of not taking unneeded steps that would bail out market participants who have taken a bath with investments tied to subprime mortgages.

San Francisco Federal Reserve Bank President Janet Yellen said on Monday that turbulence in financial markets and a tumbling housing sector had created “significant downward pressure” on the economy.

On the same day, though, Dallas Fed President Richard Fisher said the economy appeared “to be weathering the storm thus far.” While neither has a vote this year on the FOMC, both will participate in the panel’s discussions.

Regardless of the outcome of Tuesday’s meeting, markets anticipate more rate cuts ahead.

Futures contracts measuring expectations for Fed policy suggest benchmark overnight rates will be near 4.5 percent by year’s-end, three-quarters of a point, or 75 basis points, below their current level, and close to 4.25 percent by mid-2008.

“A plausible range on the extent of the anticipated Fed easing in the coming months might lie between 75 basis points and 125 basis points,” said Thomas Lam, Treasury economist at United Overseas Bank Group in Singapore.

Once the Fed tilts policy in a new direction, a series of rate moves are usually in store, although the size and speed of subsequent shifts in credit costs can vary.

Since the late 1980s the average reduction in the target rate in an easing cycle has been about 175 basis points, a figure skewed by the 550 basis points reduction seen in 2001 through 2003. A basis point is one hundredth of 1 percent.

“The Fed has usually reduced the target fed funds rate by at least 75 basis points,” Lam said.

Robert Barbera, an economist at ITG Hoenig in Rye Brook, New York, sees economic growth over the second half of the year slipping to a sluggish 1.3 percent annual pace, and thinks the Fed could be forced to push the target funds rate as low as 4 percent over the next few quarters to avert recession.

“Rising joblessness amid meager real economic growth is a strikingly disappointing backdrop, all the more so if you are a newly minted Fed chairman,” he said. “If the U.S. is entering a recession with the core (inflation) below 2 percent, it will be labeled a policy error.”

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