Debate Growing Over How Much Fed Should Cut Rates

The Federal Reserve began a two-day meeting Tuesday that is widely expected to lead to a cut in interest rates of at least a half-percentage point to calm a global credit crisis threatening the economy.

A Fed official said the gathering got underway at about 2 p.m. The policy-setting Federal Open Market Committee is expected to announce its decision around 2:15 p.m. Wednesday.

Ten out of 14 big bond firms polled by Reuters forecast the U.S. central bank will opt to lower the overnight federal funds rate target a half point to 1 percent. That would be the lowest since June 2004 when the Fed was fighting a perceived risk of deflation, a danger some fear is about to re-emerge.

Financial futures markets were even more gloomy, implying a 44 percent likelihood the Fed would lower borrowing costs by a dramatic three quarters of a point, which would take them to territory not visited since July 1958.

Some market participants think the Fed may be on the way to cutting rates all the way to zero, as Japan was forced to do to counter deflation in the 1990s.

A more-forceful three-quarter point cut would be insurance against a deflation risk. However, other analysts said the the lack of a clear deflationary threat at this stage may lead the Fed to opt for the more-incremental half-point move.

"Given that deflationary forces from the collapse of the credit cycle have still not been seen, the FOMC may be reluctant to deliver a larger rate cut," said Marc Chandler, chief global currency strategist at Brown Brothers Harriman.

He noted that some forward-looking measures of inflation had actually risen since the Fed took part in an unprecedented, globally coordinated half-point rate cut on Oct. 8 aimed at stemming cascading stock market losses.

Deflation is a general ongoing decline in prices and was at the root of Japan's 'lost decade' of stagnation in the 1990s. In a deflationary environment, consumers pare spending in anticipation of lower prices and the real cost of debts soar, leading to a rise in defaults and bank failures.

Should Fed cut rates to zero? Watch video at left.

With rates pegged at zero, Japan had to escape its deflationary trap through "quantitative easing" —flooding the financial system with liquidity to get the money supply circulating faster.

The Fed has already injected over $1 trillion into markets to thaw them out, at times letting the federal funds rate drop below the current official target of 1.5 percent, which some say adds up to a stealthy introduction of quantitative easing.

The statement the Fed will issue announcing its rate decision may also contain important hints on the future.

Investors have already had a preview in the form of the statement issued Oct. 8. This acknowledged market strain would crimp spending while inflation was fading as a risk, due to weaker commodity prices and mounting U.S. economic slack.

Steep drops in the cost of crude oil and other commodities are likely to drag the U.S. consumer price index down sharply in the months ahead. Many analysts expected the year-on-year CPI reading to fall into negative territory.

While this may not mean a broad deflation is setting in, it is likely to keep the Fed on red alert.

"Even if deflation is unlikely, officials will want to counter any increase in real interest rates as inflation tumbles," Morgan Stanley economists told clients Monday, adding that a half-point rate cut was "virtually certain." Real interest rates rise as inflation falls, tightening monetary conditions faced by borrowers even if policy remains steady.

Copyright 2008 Reuters. Click for restrictions.