Will the Fed Give Investors A Trick or a Treat?

The Federal Reserve is still expected to lower benchmark borrowing costs later today despite unexpected signs of strength in the economy.

The government reported this morning that the gross domestic product grew a surprisingly robust 3.9% in the third quarter, well above what economists had been predicting. The increase was fueled by a pickup in consumer spending and stronger exports.

AP

Fed officials, who will announce their decision around 2:15 p.m., have offered few clues on their likely course of action. Yet, despite the strong GDP report, financial markets are betting that policymakers will cut overnight interest rates by a quarter-percentage point, to 4.5%.

"Certainly the GDP number was much stronger than anticipated and that may lead to some second-guessing about what the Fed may do this afternoon, coming on top of that ADP
number which was also much stronger," said Scott Brown, chief economist with Raymond James in St. Petersburg, Florida.

A cut in rates today would follow last month's surprisingly large half-point reduction -- a move Fed officials had hoped would put them out in front of any potential economic weakness.

"In an economic expansion that had already slowed, leading sectors continue to display surprising softness and further cautious policy action can help to contain a widening out of the damage," Citigroup economist Robert DiClemente wrote in a recent analysis.

But that view is not universally held. Some analysts think the Fed may determine housing woes are not crimping consumer or business spending and may decide the best course is to hold rates steady out of concern a misstep might ignite inflation.

Gloomy Economic Data

Before today's GDP report, a parade of gloomy economic data had suggested the economy will be weaker in coming quarters than anticipated by the Fed.

On Tuesday, data showed U.S. consumer confidence slipped for a third straight month in October, while home prices posted their biggest drop in 16 years during August.

But one school of thought holds that markets have overestimated the Fed's appetite for another rate reduction and that the economy, while growing modestly now, is already poised for a pick-up next year.

This hold-steady argument gained prominence with a Wall Street Journal article published late on Monday that said the Fed was weighing the risk that a rate cut would fuel an inflationary psychology.

The question for the policy-setting Federal Open Market Committee is whether recent economic data suggests that its view of the outlook needs to be revised.

"Once we get through any near-term weakness caused by the extra downleg from the housing contraction and any spillover from tighter credit conditions, I am looking for moderate growth with high levels of employment," Fed Vice Chairman Donald Kohn said on Oct. 5.

In addition, Fed officials have said that the financial market turmoil of late summer, which prompted the central bank to act boldly to protect the economy, has eased.

"Our guess is that the FOMC won't see a compelling case for another rate cut this month, and will remain on hold," Wrightson ICAP economists wrote. 

Risk Judgment

Still others are forecasting the central bank will cut by an aggressive half-point again in a bid to decisively prevent credit conditions from tightening any further.

However, as the Fed awaits more data on the economy, the middle-course quarter-point cut may allow the central bank to avoid roiling financial markets while providing an extra measure of protection for the economy without a big risk of stoking inflation.

"When the committee sits down ... and has to judge between the risk of doing too much -- inflation could accelerate in 18 months -- or too little -- fragile financial markets could collapse and/or the economy could sag into recession -- we believe that the Fed will not hesitate to buy another (quarter-point) worth of insurance," said Stephen Stanley, chief economist of RBS Greenwich Capital.

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