Fed Expected to Make Small Rate Cut, Then Pause

The Federal Reserve looks set to deliver a small interest rate cut on Wednesday, though the central bank could signal that this is the last in a cycle as officials eye inflation warily.

The Fed has already cut interest rates to 2.25 percent from 5.25 percent in six steps since mid-September in an effort to keep U.S. economic activity going in spite of a credit crunch and a deep housing downturn.

Food, fuel and raw material prices are rising, boosting inflationary pressures, a Fed report said recently.

"This meeting's accompanying statement poses a special challenge for the committee -- justify easing another quarter point to avoid a deeper recession, and simultaneously acknowledging the risk of commodity inflationary pressures," RBS Greenwich Capital analysts David Ader and Ian Lyngen said in a research note.

Interest-rate futures prices imply about an 80 percent probability of a further quarter-point reduction and about a one-in-five chance of no move at all when the Fed wraps up a two-day meeting on Wednesday.

The government reports on first-quarter U.S. gross domestic product Wednesday.

Economists polled by Reuters expect the economy expanded at a sickly 0.2 percent annual rate, which would be the weakest since the closing months of 2002.

In addition to cuts in benchmark rates, the U.S. central bank has unleashed a series of emergency measures, sometimes in coordination with other central banks around the world, to keep banks and major financial firms lending and borrowing.

In a dramatic intervention last month, it stepped in to prevent the failure of wounded investment bank Bear Stearns.

With some signs financial markets are stabilizing, Fed officials expect the combined effects of rate cuts and a $152 billion government stimulus package to revive the economy.

They are likely to discuss whether borrowing costs are appropriately positioned to aid recovery without fostering inflation.

Their statement will provide clues to the tone of that debate.

Following are some factors Fed policy-makers will be considering on Tuesday and Wednesday:

LIQUIDITY: Fed officials are worried about continued signs of strains in short-term funding markets, as evidenced by elevated risk premiums institutions are continuing to pay.

Elevated spreads between the London Interbank Offered Rate, a gauge of what banks charge each other for loans, and overnight indexed swaps, a measure of anticipated central bank interest rate targets, fuel those concerns.

Policy-makers have offered more than $400 billion in liquidity to banks and primary dealers in Treasury securities, and suggest they are ready to bring more liquidity measures to bear if necessary to restore normal market functioning.

INFLATION: Fed officials are hearing from their contacts around the country that food, fuel and raw material prices are rising and contributing to inflationary pressures, the central bank's Beige Book survey released on March 16 showed.

Also, two members of the Fed's interest-rate setting committee voted against the March decision to cut rates by a sharp three-quarters of a percentage point, preferring less aggressive action and citing the potential for higher inflation -- and higher inflation expectations -- as a worry.

But other Fed officials believe that higher-than-desirable levels of inflation will not persist as the slowing economy raises unemployment levels.

RECESSION WATCH: The economy is growing sluggishly and possibly even contracting.

Of most concern to policy-makers is evidence from measures of confidence that the slowdown is driven by a retrenchment in consumer spending, rather than in business investment.

However, Fed officials' chief concern is that growth could brake more than expected.

Gloomy consumer sentiment could feed a sharper slowdown and persistently tight credit could neutralize the effect of Fed rate cuts in providing a boost to economic activity.

Finally, housing markets remain very weak.

But policy-makers expect those doldrums to lift over the course of the year and look for housing to exert less of a drag on economic growth in coming quarters.

RECENT COMMENTS: Dallas Federal Reserve Bank President Richard Fisher, April 22: "It's really a question of, are we getting the bang for the buck (from interest rate cuts). And clearly we're not. The system is sputtering."

Philadelphia Fed President Charles Plosser, April 18: "A slowing economy is no guarantee of slowing inflation pressures. The role of monetary policy is to ensure the stability of the purchasing power of the nation's currency, so that markets are not distorted by inflation. To insure the credibility of monetary policy we should never ask monetary policy to do more than it can do."

Fed Chairman Ben Bernanke, April 2: "Overall, the near-term economic outlook has weakened relative to the projections released by the (Fed) at the end of January. It now appears likely that real gross domestic product will not grow much, if at all, over the first half of 2008 and could even contract slightly."

"We expect economic activity to strengthen in the second half of the year, in part as the result of stimulative monetary and fiscal policies; and growth is expected to proceed at or a little above its sustainable pace in 2009, bolstered by a stabilization of housing activity, albeit at low levels, and gradually improving financial conditions."

"However, in light of the recent turbulence in financial markets, the uncertainty attending this forecast is quite high and the risks remain to the downside."

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