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Traders consider Fed rate cut a certainty

Renewed turbulence in markets puts pressure on Fed to pump up economy

(WASHINGTON) Federal Reserve chairman Ben S Bernanke may have to risk becoming the proverbial ‘fool in the shower’ to keep the US economy out of recession.

Renewed turbulence in financial markets puts Mr Bernanke, 53, under pressure to open the monetary spigots wider to pump up the economy.

Traders in federal funds futures are betting it’s a certainty the Fed will cut its benchmark interest rate from 4.5 per cent today, and they see a better-than- even chance the rate will be 3.75 per cent or below by April.

‘The Fed has to assure the markets that it’s ready to ride to the rescue and cut rates by as much as necessary,’ says Lyle Gramley, a former Fed governor who’s now a senior economic adviser in Washington for the Stanford Group Co, a wealth-management firm.

The danger of such a strategy is that Mr Bernanke may become like the bather, in an analogy attributed to the late Nobel- Prize-winning economist Milton Friedman, who gets scalded after turning the hot water all the way up in a chilly shower.

The monetary-policy equivalent would be faster inflation or another asset bubble in the wake of aggressive Fed action to tackle the slowdown in the economy.

Mr Bernanke opened the door to a rate cut at today’s meeting when he signalled in a speech on Nov 29 that the market turmoil had led to tighter credit conditions that might slow economic growth.

‘The odds of something more than a 25 basis-point cut in the funds rate are pretty good,’ says Louis Crandall, a former New York Fed official and now chief economist at Wrightson ICAP LLC, a Jersey City, New Jersey-based bond research firm.

He expects the Fed to twin a quarter percentage-point cut in the funds rate, charged on overnight loans between banks, with a half-point reduction in the Fed’s 5 per cent discount rate. That’s the rate the central bank charges on its direct loans to commercial banks.

Narrowing the difference between the two might encourage more banks to borrow from the Fed and help relieve some of the stress in the money markets.

Former Fed governor Lawrence Meyer, who also expects a quarter-point cut in the funds rate, says the central bank needs to signal in its statement after the meeting that it’s open to doing more.

‘It would damage the market’s confidence if they don’t,’ says Mr Meyer, now vice-chairman of economic forecaster Macroeconomic Advisers LLC in St Louis. ‘You don’t want to send a message that we’ll only ease policy over our dead bodies.’

Money-market interest rates have jumped during the last month as lenders hoarded cash to buttress year-end balance sheets. Also driving rates up: concerns about losses on securities linked to mortgages at risk of default. The rate on three-month loans between banks rose to 5.14 per cent on Dec 7 from 4.9 per cent on Nov 7.

The credit squeeze poses a double-barrelled risk for the economy. In the short run, there’s the danger that a major institution might encounter financing problems before the end of the year.

‘The risk of a financial accident is vastly greater than it was three months ago,’ says Mr Crandall, whose firm is a unit of ICAP plc, the world’s largest broker for banks and other financial institutions. ‘A lot of firms are running on Plan C in dealing with the turmoil, and they don’t have a Plan D.’

 

Source: Bloomberg (Business Times 11 Dec 07)

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