Fed Expected to Cut Rates, But It May Not Help Much

The still-tight credit markets are anticipating a half-point interest rate cut from the Federal Reserve this week, but investors are worried it won't be enough to quickly revive the economy.

The Fed has been slashing rates and taking unprecedented action to get market participants back in the lending mood, including launching a facility Monday to buy the short-term corporate debt known as commercial paper.

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But the central bank has already reduced its key rate—the target federal funds rate—to 1.5 percent. After the Fed's meeting Wednesday, the market predicts it will be down to 1 percent—the same low level it reached in 2001 under former Fed Chairman Alan Greenspan.

From there, policy makers have little room to lower rates further.

"We're really getting to the end of the rope," said Kevin Giddis, managing director of fixed income at Morgan Keegan. And, he said, to think that the upcoming rate cut will turn the economy around in a short period of time "is a bit optimistic."

Libor, or the London Interbank Offered Rate, is the average rate banks charge one other for loans. This rate among U.S. and European banks edged only marginally lower Monday, suggesting credit is a bit looser a few weeks ago, but still tight.

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Christopher S. Rupkey, chief financial economist in Bank of Tokyo-Mitsubishi UFJ's economic research group in New York, said he hopes Wednesday's anticipated rate cut by the Fed will be "the final blow that brings Libor down here. They're running out of ammunition."

Earlier this month, the Fed said it would start buying high-quality commercial paper to boost the market. Commercial paper is the short-term debt that companies sell for their short-term financing needs. Sometimes it is unsecured; other times, it is backed by assets such as mortgages.

Demand for the paper dried up after Lehman Brothers Holdings's bankruptcy and other troubles in the global banking system. The biggest buyers of commercial paper are money market funds—some of which took big hits when Lehman collapsed.

The Fed launched its facility Monday, charging rate of 1.88 percent to buy unsecured commercial paper, plus a 1 percent surcharge, and a rate of 3.88 percent for asset-backed commercial paper.

Overall, commercial paper rates Monday were modestly higher than they were Friday, said Bianco Research strategist Howard Simons.

But for 90-day unsecured paper and 90-day asset-backed paper—the type of paper the Fed is offering to buy—rates were lower, Simons said.

What's more important than the day-to-day rate movements, though, is the amount of paper being sold. It will likely take some time for volumes to return to the markets following the Fed's actions.

"The fact that they're going to get money moving in the commercial paper market is probably going to help a lot," Simons said.

The market for commercial paper has dropped for six straight weeks.

As of last Wednesday, commercial paper outstanding stood at a seasonally adjusted $1.45 trillion—down from $1.82 trillion six weeks ago, and well below the $2.2 trillion seen when the market peaked in the summer of 2007.

As those markets have dried up, companies have gone to their banks for loans instead.

The Fed reported last week that commercial and industrial loans by banks surged $98 billion between Sept. 10 and Oct. 15 to $1.6 trillion.

American Express was posting a rate of 2.88 percent on its unsecured paper to market buyers Monday—matching the Fed's asking rate, essentially—while General Electric was posting a rate a bit above 3 percent to market buyers, said Morgan Keegan's Giddis.

It was unclear whether the Fed had bought any paper yet, Giddis said.

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