Fed Rate Cut Appears Less Likely As Credit Markets Stabilize

As financial markets appeared to calm Monday, so did speculation that the Federal Reserve would quickly cut interest rates.

The Fed, along with European and Japanese central banks, continued to add funds to the global credit markets Monday, triggering a rebound in stocks. Goldman Sachs also said it doesn't plan to unwind two troubled hedge funds and will inject $3 billion into one of them.

With credit panic subsiding, more experts appeared to reinforce the view that the added liquidity from central banks was enough to prevent a credit meltdown, making a Fed rate cut unnecessary for now.

"I think a lot of people are expecting a September rate cut already, at least if you look at Fed Funds futures," says Sam Stovall, chief investment strategist at Standard & Poors. But "I am not as certain as the fed funds futures that the Fed will do this. They’ve been able to respond with liquidity to stabilize the market."

Northern Trust chief economist, Paul Kasriel is wary of talk about a pre-September rate cut saying, "the Fed would not do this unless the situation got extremely dire and market troubles were having a profound negative impact on the economy."

"The Fed will try to keep the Fed Funds rate at 5.25% through aggressive open market operations," says Kasriel, who adds that "they could make life easier if they cut the discount rate to 5.5%. Banks could borrow at their will whatever they need which would surpress the Fed Funds rate." 

The discount rate, currently 6.25%, is what the Fed charges banks for short-term loans. The Fed rarely adjusts only the Discount Rate when setting monetary policy.

Kasriel is in the camp of believing the Fed will eventually begin to cut rates to prevent a recession rather than bailing out the financial markets.  He thinks "the Fed will wait until the end of October to begin cutting rates."

U.S. economists at Goldman Sachs hold similar views.  In a weekly note to clients the economists say, "The Fed would prefer to resolve the current crisis through an increased supply of credit at the current funds rate target rather than a reduction in this target. This is because the current problem is one of availability of funds rather than cost."

Adds Robert Hormats, vice chairman of Goldman Sachs International, "I think they can wait (to cut rates), what they’re trying to do is to create a lot of liquidity.  If the economy weakens, or if the jobs picture begins to look a lot more troublesome then they will cut, but it will be in response to real economic developments as opposed to the current issue which is a liquidity one." 

S&P's Stovall actually thinks the Fed could make things worse if it cut rates too soon.

"The worry is lower U.S. short-term rates would make our Treasurys less attractive for overseas investors to hold," he said. That, he added, "could boost the yield on the 10 year Treasury a little higher if those investors dumped their holdings, exacerbating our housing troubles."

As a result, Fed Chairman Ben Bernanke "is probably singing Johnny Cash's 'I Walk The Line,'"  Stovall continued. "He doesn’t want to lower rates and give the assumption things are worse than thought, but also doesn’t want to leave rates alone  and inhibit liquidty."