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Sickly Credit Markets to Keep Fed on Track for Cut

Sickly credit markets and a worsening housing slump may force the Federal Reserve to cut interest rates again this month despite a less dire employment outlook.

Central bank officials have gone out of their way to argue that last month's aggressive half percentage point rate cut was not a bail out of Wall Street, but rather insurance against the broader effects of the credit crisis.

But despite modest signs of improvement in the credit markets, things are far from normal.

The housing market just keeps getting worse despite widespread forecasts it would soon hit bottom, a trend that could further compromise financial institutions and once again tighten the noose on lending.

Federal Reserve Board Chairman Ben Bernanke delivers the board's Monetary Policy Report to the Senate Banking Committee in Washington Wednesday, July 19, 2006. "The recent rise in inflation is of concern," and possible increases in the prices of oil as well as other raw materials "remain a risk to the inflation outlook," Bernanke said. (AP Photo/Dennis Cook)
Dennis Cook
Federal Reserve Board Chairman Ben Bernanke delivers the board's Monetary Policy Report to the Senate Banking Committee in Washington Wednesday, July 19, 2006. "The recent rise in inflation is of concern," and possible increases in the prices of oil as well as other raw materials "remain a risk to the inflation outlook," Bernanke said. (AP Photo/Dennis Cook)

This makes the Fed is likely to cut rates again at it next meeting in the last two days of October, despite a new report showing the labor market is not faring as badly as once believed.

"Some traders may think that this will keep the Fed on the sidelines, but it doesn't take them out of the picture," said Gary Thayer, chief economist at A.G. Edwards & Sons.

Futures markets are now split down the middle regarding the chances of an October reduction in rates.

But even the employment report contains elements that would point to another Fed move.

The economy did add 110,000 new jobs in September, beating forecasts. August's surprise contraction was also revised away to show a gain of 89,000.

Yet the unemployment rate rose, dispelling fears by policy-makers that a tight job market would put upward pressure on inflation.

"A rising unemployment rate is more or less a done deal," said Ian Shepherdson, chief U.S. economist at High Frequency Economics. "Nothing motivates the Fed to cut rates more than a loosening labor market."

In addition, the trend of ever more subdued hiring remains firmly in place.

"What counts is that household employment has averaged just 100,000 over the past six months compared to 225,000 over the previous six months," Shepherdson added.

True, some of the worst dislocations in credit markets, which in part prompted the Fed to push rates lower, have subsided somewhat.

Commercial paper issuance over the past week showed its first signs of life since the credit crunch began in early August. Some key interbank lending rates, which had been behaving erratically, have come down. A decline in discount window borrowings also suggests banks are less need of immediate cash.

This has encouraged investors to once again dip their toes into risky assets, with stock markets worldwide reaping the benefits -- pushing major averages to record highs from Wall Street to Brazil.

However, analysts say the Fed's rate cut and, importantly, expectations of further steps, have largely underpinned this improvement. Take away the stimulus, pessimists say, and the markets are back to square one.

And then there is history: it is very rare for the central banks to cut rates just once and then call it day.

"The economy is nowhere near recession, but that does not mean that the Fed does not need to be concerned about the problems we are seeing in the financial markets," said Mark Vitner, economist at Wachovia in Charlotte, North Carolina.

"Those problems are a threat to economic growth in the fourth quarter and the first quarter of next year. They are likely to cut rates again."