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Fed Playing Middle Ground On Cutting Rates

Whether by dumb luck or intelligent design, Federal Reserve officials appear to have
squeezed their way out of a dangerous policy trap.

A surprise contraction in the U.S. labor market during August, the first in four years, prompted investors across financial markets to bet the central bank would have to resort to a heftier interest rate cut next week.

Federal Reserve Board Chairman Ben Bernanke delivers the board's Monetary Policy Report to the Senate Banking Committee in Washington Wednesday, July 19, 2006. "The recent rise in inflation is of concern," and possible increases in the prices of oil as well as other raw materials "remain a risk to the inflation outlook," Bernanke said. (AP Photo/Dennis Cook)
Dennis Cook
Federal Reserve Board Chairman Ben Bernanke delivers the board's Monetary Policy Report to the Senate Banking Committee in Washington Wednesday, July 19, 2006. "The recent rise in inflation is of concern," and possible increases in the prices of oil as well as other raw materials "remain a risk to the inflation outlook," Bernanke said. (AP Photo/Dennis Cook)

But a series of conflicting speeches from policy-makers early this week has left room for doubt, giving the Fed just the flexibility it needs to make what everyone agrees is one of the most treacherous rate decisions in recent memory.

Getting backed into a corner is the last thing the Fed needs at a time when rising uncertainty has made financial markets prone to wild swings.

While a worsening job outlook makes some monetary easing seem all but inevitable, lowering rates by just a quarter rather than half point is now at least an option.

Luck and Buying Time

"It was a combination of luck and buying themselves time," said Mary Ann Hurley, a senior trader at D.A. Davidson in Seattle. "I don't believe they have to go 50 basis points."

True, futures markets are pricing in a solid chance of such a move from the current 5.25% federal funds target. But of 20 primary bond dealers polled by Reuters, only six believe the central bank will be that aggressive, indicating investors are keeping an open mind about the Fed's likely course of action.

The Fed meets on Tuesday against the backdrop of tense credit markets, with banks leery of making any loans before they know just who might hold significant exposure to tarnished mortgage debt.

A severe housing downturn has been compounded by tighter credit conditions, with a report on Tuesday showing around as many as one third of mortgages originated last month were
eventually canceled.

Signs that the labor market was finally falling prey to the weakening housing market seemed like the last straw for Wall Street. The Fed, many reasoned, would need to slash rates by a
half percentage point in order to stave off a possible recession.

Yet bold action could well have unintended consequences.

Dollar Hits Low

The dollar, which fluctuates closely in line with interest rates, is already at an all-time low against the euro and is little better off against many other currencies.

A half-point cut could spur a disorderly run for the exits, and push market interest rates higher over the longer-term as global investors shun U.S. assets like Treasury bonds -- just the
opposite effect desired by the central bank. Fed chairman BenBernanke himself warned of this threat in a speech on Tuesday.

Moreover, a big rate cut could lend the perception that officials are getting a bit desperate and send an already volatile stock market into full flight.

Developments on the ground could still force the central bank's hand. A decline in August retail sales to be released on Friday could lead to another rally in the bond market and all but
cement expectations for a bigger move.

For the moment though, internal disagreement has bought the Fed some time.

Debate at Fed

"The recent remarks are consistent with a debate at next week's meeting between a 25-basis-point and a 50-basis-point ease," wrote JP Morgan Economist Michael Feroli in a research
note.

On the one hand, Fed Governor Frederic Mishkin and San Francisco Fed President Janet Yellen appeared to focus on the downside risks to growth from the ongoing credit crunch. They
appeared more comfortable with a sharper adjustment in rates.

But inflation hawks Charles Plosser and Richard Fisher were more sanguine on U.S. growth prospects, arguing fundamentals were sound and warning against overreacting.

The markets reacted by unwinding some of their more aggressive rate views, leaving the Fed room to choose.

"The Fed hasn't really fought very hard against rate-cut expectations but it hasn't banged the drum about anything aggressive either," said Kim Rupert, global fixed-income strategist at Action Economics.

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