GO
Loading...

Wall Street: More Rate Cuts Still Possible But Not Likely

Reuters
Thursday, 22 May 2008 | 4:13 PM ET

Wall Street appears resigned to the idea that the Federal Reserve is done cutting interest rates, but a patchy economy could force policy-makers to keep their scissors handy.

AP

The conviction that the central bank's aggressive rate-slashing campaign has ended is founded in part on hopes that the worst of the credit crunch is over.

There is also simple arithmetic.

At 2 percent, benchmark rates are pretty low already, especially against a backdrop of relentless price increases in energy and commodities.

However, some analysts say forecasts that benchmark borrowing costs have hit bottom are premature.

They note that since the credit crisis struck, Fed Chairman Ben Bernanke has exhibited a willingness to act aggressively, even if that goes against the wishes of some other officials.

"We still look for the Fed to cut," said Carl Riccadonna, an economist at Deutsche Bank who sees the central bank lowering rates in December and early next year after a breather.

"The economy is growing well below the trend rate, and that means that ultimately you will see the unemployment rate move higher," he said.

Since mid-September, the Fed has cut overnight rates by 3.25 percentage points to 2 percent.

In minutes of its last meeting released Wednesday, the central bank signaled further reductions were unlikely and interest-rate futures prices show traders expect rates to be at least a quarter-percentage point higher by year end.

However, even if credit conditions improve, the full impact of the U.S. housing slump on the rest of the economy has yet to be felt, meaning more pain and possibly more Fed action.

"Economists tend to be impatient, calling turns too early," said Christopher Low, chief economist at FTN Financial.

Indeed, forecasts accompanying the Fed minutes showed officials had grown more gloomy on the outlook.

They now see the economy growing just 0.3 percent to 1.2 percent this year, compared with the 1.3 percent to 2 percent they estimated in January.

"They clearly see downside risks to their growth forecasts," said Jim O'Sullivan, economist at UBS Warburg in Stamford, Conn.

"There's certainly no optimism there." Still, the meeting minutes said several officials believed rates should not move lower even if the economy deteriorated, and a string of recent speeches have underscored growing inflation concerns.

That suggests the bar to further easing may be high, but perhaps not insurmountable.

"If the tax rebates are saved not spent and markets don't improve, then their next action may well be an easing," said Vincent Reinhart, a former top Fed economist. "But, barring an adverse market development, it'll take some time to convince policy-makers of that."

In his latest pronouncement, Bernanke made clear he was still worried about the health of credit markets. "Conditions in financial markets are still far from normal," Bernanke said. "Ultimately, market participants themselves must address the fundamental sources of financial strains. This process is likely to take some time."

He was followed swiftly by European Central Bank President Jean-Claude Trichet and billionaire businessman Warren Buffett, who both warned Monday that there was no end in sight to global credit woes.

On the same day, Meredith Whitney, a prominent banking analyst with Oppenheimer & Co, slashed her earnings outlook for top U.S. banks. "We believe what lies ahead will be worse than what is behind us," she said.

If markets do take another turn for the worse, the Fed could set aside its inflation concerns.

In the early 1980s, while studying the Great Depression, Bernanke theorized that financial markets could aggravate an economic downturn by fueling a vicious cycle that deepened and prolonged the pain.

"A particularly destabilizing aspect of this process was the tendency of fears about the soundness of banks and expectations of exchange-rate devaluation to reinforce each other," he wrote at the time.

While Fed officials hope they have averted such an adverse feed-back loop, it is hard to see why Bernanke would risk letting one set in if troubles flared anew.

"I frankly do not see how they could refrain from further easing," said Mary Ann Hurley, vice president of fixed-income trading at D.A. Davidson & Co in Seattle.

Featured

Contact Economy

  • CNBC NEWSLETTERS

    Get the best of CNBC in your inbox

    › Learn More