Grim market mood could goad Fed into a rate cut today

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A week ago, it’s fair to say, Federal Reserve policymakers had absolutely no intention of cutting their benchmark short-term interest rate at today’s regularly scheduled meeting.

But things look a little, uh, different in the financial landscape compared with seven days ago. Lehman Bros. Holdings Inc. is in bankruptcy, Merrill Lynch & Co. had to rush into the arms of Bank of America Corp., and insurance giant American International Group is desperately seeking at least $70 billion in loans to stay afloat.

Although Fed Chairman Ben S. Bernanke almost certainly would prefer to hold the central bank’s rate steady at 2%, frazzled markets may call the Fed’s tune.

Fearful of continued upheaval in the financial system from the unwinding of Lehman Bros. and from AIG’s woes, major banks, brokerages, hedge funds and other Wall Street players were hoarding cash on Monday. If that doesn’t abate this morning the Fed could feel pushed into a corner.

The hoarding was evident in the surge in the federal funds rate, the rate the Fed targets, to as high as 6% early Monday. The fed funds rate is what banks charge one another for overnight loans. It rocketed because big investors ‘just don’t want to part with their cash very easily,’ said Brian Edmonds, head of interest rates at brokerage Cantor Fitzgerald in New York.

Why the desperation for short-term funds? One answer is that Wall Street isn’t sure of the magnitude of the fallout from Lehman and AIG. How many banks, hedge funds, brokerages and other market players could find themselves strapped for money because Lehman or AIG can’t make good on a previously arranged transaction, such as a credit-default swap? Nobody knows -- so when it doubt, build up your cash, and fast.

Yet the Fed already is making plenty of money available to banks and major securities dealers via short-term lending programs launched or expanded since spring. That’s an argument for staying the course with a 2% federal funds rate, and simply encouraging financial firms to make more use of the programs, says Joe LaVorgna, chief U.S. economist at Deutsche Bank Securities.

Still, he said, ‘a rate cut is possible . . . if policymakers believe it will stabilize market psychology.’ And if they decide it’s needed for that reason, it would make sense for the Fed to make the cut a half-percentage point, to 1.5%, rather than a quarter of a point, LaVorgna said.

The risk? A Fed rate reduction could reverse the dollar’s recent rally, which has been supported by the idea that U.S. interest rates would be heading higher in 2009 (a bet on a stronger economy). And the inflation-fighter image the Fed has been trying to project since May would take a serious hit.

But if the decision is between preserving the financial system and looking tough on inflation, it’s pretty obvious which road the Bernanke Fed is going to take.