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
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
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.