Fed's Balancing Act On Rate Cut Getting Tougher

Fed Chairman Ben Bernanke’s latest assessment of the economy shows the central bank’s job of balancing inflation with a slowing economy is more difficult than ever, leaving policymakers undecided on further rate cuts.

A week after lowering interest rates for the second time in six weeks, Bernanke told the Joint Economic committee of Congress that economic growth would “slow noticeably’ in the fourth quarter as the credit crunch continues. At the same time, he said, recent improvement in core inflation could be short-lived because of “important upside risks” from rising commodity prices and a weakening dollar.

Mary Altaffer / AP Federal Reserve Chairman Ben Bernanke.

“The Fed sees growing risk on either side,” said Robert Brusca, chief economist of Fact And Opinion Economics. “The Fed is stuck with a very difficult decision.”

Brusca echoed other economists in concluding that the central bank is undecided about whether to cut rates at its December meeting. The key federal funds rate now stands at 4.50 percent.

The uncertainty didn't help the stock market, which waivered during Bernanke's morning testimony and then fell sharply in the afternoon.

No Fed Bailout

"The market is falling because it is coming to the realization that the Fed can't bail us out on these credit issues," said James Awad, chairman of WP Stewart Asset Management. "The Fed is reluctant to give the impression or the promise that is going to lower again and get backed into the corner it was in before."

Bernanke’s appearance on Capital Hill comes at a time of when major Wall Street firms such as Merrill Lynch , Citigroup  and Morgan Stanley  are revealing sizable losses related to the credit crunch that was once thought to be largely limited to mortgage-focued firms like Countrywide Financial and homebuidlers.

In addition, Congress – in keeping with its somewhat populist tendencies in a presidential election year – is growing increasingly restive on the mortgage meltdown and its impact on voters.

Prior to the hearing, committee chairman Charles Schumer (D-NY) told CNBC that "there's a lack of confidence in the market," adding he blamed the Bush administration more than Bernanke "in being behind the curve."

In that interview, Schumer appeared to carefully avoid outright criticism of the Fed chief, whose actions reflected a "hands off attitude" on what Schumer described as worrisome issues such as the weak dollar, high oil prices and a lack of credit.

Housing-Credit Quagmire

The Fed chairman’s testimony Thursday was quick to cite the housing-credit quagmire as “downside risks” to the central bank’s economic assessment.

The speech cited the possibility that financial market conditions could “fail to improve or even worsen”, credit conditions could become “even more restrictive” and housing prices might “weaken more than expected”,  having a negative impact on consumers and investors.

How all of that plays out is probably the difference between a recession or not.

David Resler, managing director and chief economist at Nomura International, said recent economic data such as the third-quarter GDP and September nonfarm payrolls was stronger than expected.

"It would probably take more compelling weakness than we've seen so far to tilt the decision to further easing this year," said Resler.

Standard & Poor’s, for one, now see’s a 40% risk of a recession, versus 35% a month ago.

“What people are trying to figure out is what is likely to happen next,” said Sam Stovall, chief investment strategist at S&P, which is still calling for another interest rate cut at one of the Fed’s next two meetings, “probably at the January meeting.”

Awad was among those to say the Fed's job had become more difficult than, say, a month ago.

"It's harder now because of dollar and oil," he said. "That limits the Fed's options. Dollar and oil have become a ying and a yang thing, self-fulfilling each other."

Three Scenarios

Stovall laid out three economic-investment scenarios.

If the Fed fails to avoid a recession, then investors should take a defensive posture, such as pharmaceuticals and utilities.

If the central bank manages a soft landing, then economically-sensitive sectors--industrials, technology--are the way to go.

Should inflation get the best of the Fed and the economy, then investors should look to energy and materials.

Investors will get a fresh look at that dynamic next week, when the government reports both PPI and CPI.

© 2009 CNBC.com