Fed Likely to Cut Rates, But How Much Is Unclear

Fed Chairman Ben Bernanke’s latest analysis of the weakening economy makes another interest rate reduction at the Dec. 11 policy meeting a near certainty, say economists, but the size of that cut is very much up in the air.

"If you read between the lines, they are certainly going to cut again," says Combinatorics Capital Managing Director Ram Bhagavatula, who represents the prevailing view of Bernanke’s speech Thursday evening.

Federal Reserve Chairman Ben Bernanke.
Mary Altaffer
Federal Reserve Chairman Ben Bernanke.

But Bhagavatula, perhaps much like the Fed’s FOMC committee itself, thinks it is too soon to say whether the federal funds rate -– now at 4.5 percent after three reductions -- will be lowered a quarter point or half a point.

That will be depend on the nature of key economic data for the month of November due out the week ahead of the FOMC meeting. The ISM index of manufacturing activity, as well as nonfarm payroll and unemployment data, are critical.

"Its all about jobs," says Christopher Rupkey, chief financial economists at Bank of Tokyo-Mitsubishi UFJ, who says the Fed might have to cut the fed funds rate by 50 basis points.

Jobs Data 'Worrisome'

Rupkey called the latest weekly jobless claims data "worrisome." He is also watching the jobless rate –- now at 4.7% -- very closely, noting that every recession in the past 30 years has been marked by a half point increase in the jobless rate from its lowest level during the proceeding economic expansion.

The jobless rate -- now at 4.7% -- hit a low of 4.4 percent in March of this year and is likely to hit 4.8 percent in November.

Bernanke acknowledged the weakening labor market but suggested it was consistent with a slowing economy and not particular worrisome. The Fed chief, however, sounded less optimistic in mentioning that he sees "some headwinds for the consumer in the months ahead."

With the exception of revised third-quarter GDP data, virtually all the economic data released this week -– from consumer confidence to weekly jobless claims to the personal income and spending figures released Thursday –- show deterioration in two areas of the economy once thought to be the remaining areas of some strength.

"Consumer confidence has fallen, so there is upside in the employment rate," noted Robert Brusca, chief economist at Fact & Opinion Economics, even before this week’s data confirmed the trend –- adding the situation increases the chance of a recession.

Recession Worries Grow

Growing speculation about a recession in the near future has been matched by predictions about how far the Fed will lower interest rates to avert one.

Economists agree that Bernanke’s speech, as well as one earlier in the week by Fed Vice-Chairman Donald Kohn, show the Fed is ready to do what is necessary.

Rupkey says they were "right in your face" about indicating the Fed’s position had changed from what was thought to be a neutral stance based on its last FOMC policy statement.

The Kohn-Bernnake speeches say "we get it," says Scott Rothbort, a professor at Seton Hall University’s Stillman School of Business and president of Lakeview Asset Management.

If so, the central bank may be playing catch up to the financial markets.

"The market is way out in front of the Fed," says Rupkey. "In a way, what else can the Fed do?"

Rupkey, who is "not quite ready" to predict a recession, says based on fed fund futures the market is looking for three rate cuts by March and the yield on the two-year Treasury is "pricing in a recession."

Lowering Target Rates

Lehman Brothers just lowered its fed funds target to 3.25 percent from 3.5 percent, close to what appears to be an emerging consensus of a 3 percent low.

Bhagavatula sees rates at 3.5 percent by mid-2008 and 3 percent or lower by the end of next year, saying "recession is going to happen" with GDP turning negative in the fourth quarter of 2007.

Rothbort, who thinks the Fed’s final three rate hikes in 2006 were "too much," says the central bank "easily has a 100-150 basis points left to go" in its easing campaign and suggests a 50 basis-point -- or half-point -- cut going into the peak of the holiday season.

Though somewhat critical of the Bernanke Fed, Roth says the chairman improved his stature with investors by improving communication, sounding less academic style and showing leadership.”

Says Rothbort: "Bernanke's speech says we realize what is going on and we will take the action and the market needs to realize I am in charge."