Benefits of Expected Fed Interest Rate Cut Debated
The Federal Reserve probably will cut interest rates at its meeting Tuesday, even as some analysts--and bond investors--worry that the central bank’s economic stimulus measures already have gone far enough.
The Fed has cut the target for its key short-term rate, the federal funds rate, 10 times this year to encourage spending by consumers and businesses, which has drooped as layoffs, recession and the terrorist attacks have taken their toll on Americans’ confidence. The fed funds rate is the overnight loan rate among banks.
On Tuesday, Fed policymakers are expected to reduce the fed funds rate from 2% to 1.75%, a new 40-year low. A Reuters poll of 24 government bond dealers Friday found that expectations of a quarter-point cut were unanimous.
But instead of speeding an economic recovery, another rate cut could serve to fuel future inflation, drive up mortgage rates and perhaps limit the Fed’s options should the economy unexpectedly worsen, some analysts say.
“We could be wasting ammunition,” said Sung Won Sohn, economist at Wells Fargo & Co. in Minneapolis. “It’s time to stand pat and let the previous rate cuts work their way through the economy.”
The Treasury bond market, meanwhile, already is anticipating a rebound in the economy and may be fretting about potential inflationary pressures that could be difficult to quell if they get going.
Yields on longer-term Treasury bonds soared last week as investors dumped the securities. The 10-year T-note, a benchmark for mortgage rates, ended Friday at 5.16%, up from 4.75% a week earlier and the highest yield since Aug. 7.
“The bond market is saying the economy will recover, and watch out” for higher inflation, said Mickey Levy, economist at Bank of America in New York. Investors are reluctant to lock in long-term yields if they fear rising inflation could eat into fixed-rate returns.
That could be bad news for home buyers and people hoping to refinance home loans. Low mortgage rates have helped boost refinancings to record levels this year and have kept home sales strong, even as the rest of the economy weakened. But the surge in Treasury yields could lead to higher mortgage rates even as the Fed drives short-term rates lower.
“That would be a perverse effect,” Sohn said.
Higher long-term yields also would make borrowing more expensive for many corporations, exactly the opposite of what the Fed hopes to achieve with its rate cuts.
Politically, however, the Fed has little choice but to cut rates again, most analysts agree. Since the central bank’s last meeting, the National Bureau of Economic Research, the official arbiter of U.S. economic cycles, has declared the nation to be in a recession. And on Friday, the government said the unemployment rate jumped to a six-year high of 5.7% in November.
“The Fed would risk a lot of political retribution if it sat there doing nothing in the face of rising unemployment and being told by the NBER that there is a recession,” said Paul Kasriel, economist at Northern Trust in Chicago. “This cut will be dictated by political issues more than economic ones.”
The stock market is expecting a cut of at least one-quarter point Tuesday, and perhaps another cut in January, analysts say. The market rallied strongly most of last week on expectations that an economic recovery is imminent and that the Fed will continue to support the economy with easier credit.
The Dow Jones industrials rose 2% last week and the Nasdaq composite index surged 4.7%, though stocks eased modestly Friday on the November employment news.
With major stock indexes at their highest levels since August, equity investors don’t yet appear perturbed by rising bond yields. Some market bulls contend that Treasury yields are rising more for technical reasons than because of inflation concerns. For example, some investors who expect a recovery are selling Treasuries to buy higher-yielding corporate bonds.
In any case, not all economists believe another Fed cut is a bad idea. Scott Grannis, economist at Western Asset Management in Pasadena, said deflation--falling prices and wages--may be a greater threat to the economy than inflation, and a rate cut now could be an inoculation against a deflationary trend taking hold.
The U.S. last experienced widespread deflation during the Great Depression of the 1930s.
Grannis believes the Fed waited too long to begin cutting interest rates, and then eased too slowly for much of this year. “I think they set in motion some deflationary forces ... and deflation is hard to stop,” he said. “In that context, a rate cut now is a good thing” if it helps spur a rebound in demand for goods and services.
At Tuesday’s Fed meeting, two new central bank governors will be voting: Susan Bies and Mark Olson, appointed by President Bush to fill vacancies open since 1999, were sworn in Friday.
