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What the Fed Is Facing at Tuesday's Policy Meeting

Wall Street widely expects the U.S. Federal Reserve to cut interest rates this week, as key
Fed policy-makers shifted stance by saying credit conditions had deteriorated and could hurt the broader economy.

The Fed is expected to cut the the benchmark federal funds rate, now at 4.50 percent, probably by 25 basis points. Markets have factored in more rate cuts down the line.

Ben Bernanke, President Bush's top economic adviser, speaks in the Oval Office at the White House after Bush named him to take over the Federal Reserve from retiring Alan Greenspan, in Washington, Monday, Oct. 24, 2005. It was the third time in as many years the president has turned to the 51-year-old Bernanke for a sensitive post. Bush named him to the Fed board in 2002, then made him chairman of the president's Council of Economic Advisers earlier this year. (AP Photo/J. Scott Applewhite)
J. Scott Applewhite
Ben Bernanke, President Bush's top economic adviser, speaks in the Oval Office at the White House after Bush named him to take over the Federal Reserve from retiring Alan Greenspan, in Washington, Monday, Oct. 24, 2005. It was the third time in as many years the president has turned to the 51-year-old Bernanke for a sensitive post. Bush named him to the Fed board in 2002, then made him chairman of the president's Council of Economic Advisers earlier this year. (AP Photo/J. Scott Applewhite)

The Fed has cut the fed funds rate by a cumulative 75 basis points since mid-September to prevent economic fallout from credit turmoil stemming from troubles in the U.S. mortgage market.

The following are some factors Fed policy-makers are considering:

Interbank Rates Surge

Interbank rates have risen sharply in the past few weeks as year-end funding needs were exacerbated by renewed concerns about banks.

The New York Fed announced on Nov. 26 that it would provide more than usual funds to cover the year-end and also eased some lending conditions.

The European Central Bank (ECB) and the Bank of England (BoE) also provided ample funding to the money market.

The BoE also cut interest rates for the first time in over two years. The ECB held rates steady.

The Fed may also cut the discount rate further on Tuesday to lower the spread between that and the fed funds rate. The spread was reduced to 50 basis points in August from 100 basis
points.

Lending at the discount window jumped to $2.15 billion on Dec. 5, the largest since September. It was the first period that covered the year-end and rates at the discount window were
lower compared with the market, which may have led to increased borrowing.

Economy Still Slowing

U.S. employers increased hiring by 94,000 jobs in November, in line with forecasts, after a revised increase of 166,000 in October.

Real gross domestic product for the third quarter was revised up to 4.9 percent, its best in four years. But growth is expected to slow substantially in the coming quarters.

Personal spending rose by an unexpectedly small 0.2 percent in October while consumer prices climbed 0.3 percent, leaving inflation-adjusted spending flat in October after a slim 0.1 percent rise in September.

The Reuters/University of Michigan Surveys of Consumers' preliminary December figure on consumer sentiment was 74.5; the index fell for the third straight month.

The Institute for Supply Management (ISM) survey showed U.S. manufacturing expansion edged down for the fifth straight month in November, to 50.8 from 50.9 in October.

The ISM's services index fell to 54.1 in November from 55.8 in the previous month.

Industrial production fell 0.5 percent in November, the first drop since May and the largest since January.

Non-defense durable goods orders excluding transportation fell by 2.3 percent in October.

Housing Slump Worsens

Housing data continued to be grim. New home sales in October were at an annual rate of 728,000 units, below market forecasts, and September sales were revised down to a
716,000-unit rate from 777,000.

U.S. housing prices posted their first quarterly drop in 13 years during the third quarter.

Pending home sales rose 0.6 percent in October, but the decline from a year ago was the third largest on record.

Housing starts rose 3 percent to an annual pace of 1.229 million units in October. Total existing home sales fell 1.2 percent in October.

Construction spending fell 0.8 percent, the biggest drop since July, and was at $1.158 trillion annual rate, the lowest in two years.

Inflation Remains Mild

The price index for personal consumption expenditures excluding food and energy costs rose 1.9 percent year-on-year in October.

U.S. import prices rose 1.8 percent in October, matching a gain in May 2006.

Oil/Dollar Factor

U.S. crude oil futures prices retreated from highs above $90 a barrel.

The U.S. dollar has steadied somewhat after hitting a record low against the euro of $1.4968 last month.

U.S. non-farm worker productivity rose 6.3 percent annualized pace in the third quarter.

Recent Comments

Fed Chairman Ben Bernanke: "The outlook has ... been importantly affected over the past month by renewed turbulence in financial markets which has partially reversed the
improvement that occurred in September and October.

Vice Chairman Donald Kohn: "Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses."

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