[NYTr] Booming Economy: Fed fights two-pronged battle on rates

[All the News That Doesn't Fit]

MSNBC - Srp 17, 2007 5:08 pm ET
http://www.msnbc.msn.com/id/20779920/

Fed fights two-pronged battle on rates

Rate cuts will calm financial markets, but could reignite  inflation
By John W. Schoen

Senior Producer
MSNBC

When the Federal Reserve’s interest rate-setting committee meets
Tuesday, it is widely expected to cut its target federal funds rate for
the first time in more than four years. But forecasters are divided on
whether the Fed will cut the benchmark a quarter-percentage point or a
more aggressive half-point as central bankers respond to the first
economic crisis since Chairman Ben Bernanke took office 19 months ago.

Fed watchers say the central bank is fighting a battle on two fronts.
On one side, it is trying to push money into the banking system,
recently cutting the rate on direct loans to banks through its
so-called discount window, to calm the storm that hit the financial
markets a month ago.

Those moves to pump money into the banking system have already pushed
the cost of money well below the Fed’s official target rate. According
to the Fed’s own data, the “effective” federal funds rate fell as low
as 4.54 percent Aug. 14 as the central bank added liquidity to put out
the fires sweeping through money markets.

The Fed tries to maintain its target rate through daily sales or
purchases of Treasury securities from primary dealers, adding or
draining cash to try to balance the supply of money with demand.

Though the target rate has since moved back above 5 percent, some
analysts suggest that the widely expected quarter-point cut Tuesday
would merely ratify what is already happening in the financial system.
That has led to some speculation that the Fed's Open Market Committee
could move more aggressively with a half-point cut in the federal funds
rate target.

Still, the Fed remains wary of letting up on its other perennial battle
front — the fight against inflation. If it cuts rates too far, it risks
creating another credit bubble or stoking inflation. Former Fed Gov.
Wayne Angell, now a private economist, believes the central bankers
can’t have it both ways.

“It's just nonsense to say that the Fed can supply reserves to the
discount window and to open market operations and without affecting the
target (federal) funds rate,” he said.  “There is only one monetary
policy. And this monetary policy is apparently confusion.”

Regardless of what the FOMC announces as its target rate, Fed watchers
will also be scrutinizing the statement that accompanies the new rate —
looking for clues about the outcome of the next regularly scheduled
meeting six weeks from now.

“I would like to see the Fed (cut a half point),” said former Fed Gov.
Lyle Gramley, now a senior adviser at Stanford Washington Research
Group. “But I think the key issue if they go (a quarter-point) is
whether the (press) release indicates more help is on the way if
needed.”

Despite the recent addition of cash to the U.S. banking system, the
global credit markets remain skittish following the implosion of
subprime mortgage-backed bonds and the collateral damage to hedge
funds, banks and other investors that are holding them. A widening fear
about the prospect of further defaults rocked the stock and bond
markets last month and raised market-based rates for some other types
of lending.

Even as short-term rates have fallen in the U.S., a widely used lending
benchmark called the London Interbank Overnight Rate, or Libor, has
risen. That’s a sign that banks and investors are afraid of further
credit fallout, so they’re demanding higher rates from borrowers to
compensate for that risk.

A cut by the U.S. central bank could help calm those lenders and
investors and restore flows of cash to some forms of borrowing that
have dried up since the credit squeeze began in early August.

“Financial conditions are tighter today than they were a month or two
ago,” said Jay Bryson, global economist at Wachovia. “In order to
offset that the Fed needs to be easing to try to bring some of those
rates down.”

But a move to cut rates is not without risks. The recent turmoil in the
credit markets is due in part to a period of easy money policy after
the dot-com bubble burst — when the Fed, under the leadership of former
Chairman Alan Greenspan, cut the benchmark overnight rate to as low as
1 percent. That policy helped fuel the lending spree that pumped U.S.
housing prices to unsustainable levels. Now that the excesses of the
housing boom have been reined in, the Fed is loath to begin another
round of cheap credit.

The Fed has also long maintained that its primary goal is to fight
inflation. On that front, it’s shown good progress: A key inflation
indicator the Fed watches closely has recently fallen below the central
bank’s perceived target of 2 percent annual price growth.

But loosening credit now could set the stage for higher inflation down
the road. Strong demand for crops used for both food and biofuels have
driven up food prices. Crude oil recently topped $80 a barrel. A strong
global economy has tightened supplies of others commodities like steel
and other building materials.

“Longer term, if the Fed is sowing the seeds of an inflation problem
and the economy turns out not to be this weak, there could be a price
to pay for this long-term,” said Michael Darda, chief economist at MKM
Partners.

Assessing the health of the economy is probably the Fed’s toughest task
at the moment. Its own survey of economic conditions at the 12 regional
member banks last month found that while the pace of economic growth is
slowing, business conditions are still relatively healthy. Recent data
on industrial production seem to confirm that view.

But last month’s weak employment report — showing a net loss of 4,000
jobs in August — came as a surprise to economists and analysts who had
been looking for gains of over 100,000 new jobs. The report also said
job growth was weaker than initially reported in June and July.

The rising pace of home foreclosures and the slowdown in mortgage
lending also poses a threat to future growth — and raises the
possibility that the recession now gripping the housing market spills
over to the broader economy. Though such a full-blown recession isn’t
inevitable, say many economists, the odds of one occurring have risen
as the housing and mortgage markets have fallen.

Former Fed governor Lyle Gramley notes that since World War II, every
downturn in housing has been followed by a recession – with the
exception of housing slumps in 1950 and 1966 “when we had big increases
in defense spending that kept the wolf at bay,” he said.

While some FOMC members may want to cut rates more quickly — by a half
percentage point — Fed watchers note that it will be easier to reach a
consensus for a quarter point cut. But Bryon is in the camp who thinks
that recent signs of economic weakness indicate that a more aggressive
cut is needed.

“If over the next few months we find out that (economic) growth is
really stronger than we think, and the economy didn’t really need the
(half point) cut, they can reverse it and they can reverse it pretty
quickly,” he said. “But I think that downside risks to growth are
starting to build at this point.”

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