Reluctant Bernanke may go with popular demand, cut key rates

WASHINGTON: Federal Reserve chairman Ben S Bernanke and his colleagues sound as if they’d prefer to just say no to an interest-rate cut this week. The financial markets may not let them. Policymakers from Bernanke on down have avoided signalling they want to reduce benchmark lending rates at their October 30-31 meeting, ever since lowering them by a larger-than-anticipated half percentage point in September. Instead, Fed officials have stressed how uncertain the outlook is and, in words Bernanke used twice in a single week, how “challenging” it is to make policy.

Traders don’t agree. They consider the chances of a rate cut this week as a cinch, judging from federal funds futures prices at the end of last week. If the Fed disappoints them, it risks upsetting still-fragile markets and hurting the economy.

“The Fed is reluctant to ease,” says Louis Crandall, chief economist at Jersey City, New Jersey-based Wrightson ICAP, a unit of ICAP, the world’s largest broker for banks and other financial institutions. “But it also doesn’t want to unsettle the financial markets unnecessarily.” The likely rationale if the Fed cuts: a desire to prevent the worst case, in which renewed market tumult, rising oil prices and falling home values drive the US economy into recession. The Fed, though, may combine such a move with an open-ended statement that doesn’t promise further cuts.

Its goal would be to dissuade investors from anticipating a series of reductions, an outlook that could further weaken the dollar and revive inflation concerns. “They’ll use the statement to try to temper expectations of further rate cuts,” says Michael Feroli, a former Fed economist who is now with JPMorgan Chase in New York.

Speculation about what the Fed will do this week has swung widely since the central bank cut its target for the federal funds rate — the rate banks charge each other for overnight loans — to 4.75% from 5.25% on September 18.
Traders in federal funds futures initially bet heavily on an October 31 rate cut, pushing the odds of such a move to 75% or more at the beginning of October. They then scaled their expectations back below 50% after the government on October 5 revised August payroll numbers to show a gain instead of a decline.

Further weakness in housing, along with dismal earnings reports from Citigroup and other big banks, helped trigger fresh market turmoil during the last two weeks, prompting traders to again raise the odds of a rate cut, with some even expecting a half-point reduction.

“The markets are yo-yoing all over the place,” says former Fed Governor Lyle Gramley, now a senior economic adviser at Stanford Group in Washington. “The Fed ought to have a cooler head.” Gramley is among a minority of economists who expect the Fed to stand pat. He says policymakers may not have enough evidence of a weaker economy to support another rate reduction now. Indeed, Fed officials don’t depict an economy in as dire straits as some in the markets do, suggesting they’d prefer to wait and see how conditions develop before cutting rates again.

While housing keeps weakening, the rest of the economy is holding up. Retail sales rose 0.6% in September, double the increase of the previous month. Business investment in computers and machinery also increased, prompting some economists to raise estimates for third-quarter growth.

Anecdotal information the Fed has gathered from business contacts, which has more weight in uncertain times, shows the economy expanding, albeit at a slower pace than when the central bank’s Federal Open Market Committee met last month. In a regional survey known as the Beige Book, none of the 12 Fed banks reported signs of a sharp contraction in growth, based on information collected through October 5.

“On balance, I would characterise the data we have received on the real economy since the last FOMC meeting as supporting our baseline forecast,” Chicago Fed president Charles L Evans said in an October 22 speech. That forecast calls for the economy to pick up over the next year to a growth rate closer to 2.5% after slowing below that level in the final quarter of this year.

Policymakers, including San Francisco Fed president Janet Yellen, have also highlighted the economy’s ability to weather financial turmoil in the past as reason to avoid overreacting to the latest market squall. They cite 1998, when stocks slumped and credit costs rose after the collapse of hedge fund Long Term Capital Management in September. Helped by three rapid-fire rate cuts by the Fed, the economy barrelled ahead, growing by 6.2% in the fourth quarter.

Like today, the Fed had problems managing expectations. After trimming rates a quarter percentage point in September, the central bank had to follow with similar reductions in October and November after the first cut failed to stabilise financial markets.

The Fed tried to avoid a similar situation last month with its half-point cut, says Laurence Meyer, a Fed governor from 1996 to 2002 and now vice-chairman of Macroeconomic Advisers of St Louis. Instead, it once again faces calls for another cut. And traders are betting it will comply once more, if only to short-circuit a renewed increase in borrowing costs in credit markets.

An economic-risk index compiled by Citigroup suggests that credit costs are rising after dropping in the aftermath of the September rate cut. Bernanke provided the likely justification for another reduction in an October 19 speech, when he discussed how to carry out policy during times of uncertainty. Rather than acting cautiously, he said then, the central bank might be better off acting boldly in response to shocks to the economy. “That approach is motivated by the notion that the perfect should not be the enemy of the good,” he said.

This wouldn’t be the first time a Bernanke-led Fed acceded to traders’ expectations. The Fed raised rates on June 29, 2006, even though some officials wondered whether the action was needed, according to minutes of the meeting. Behind the increase: rising inflation expectations in the month before, as measured by Treasury inflation-protected securities.