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THE FED: 25 Or 50? -- Bernanke's Fed Faces A Key Test

By Greg Robb

WASHINGTON (Dow Jones) -- When Federal Reserve Board Chairman Ben Bernanke sits down to write his book, the odds are that there will be a chapter on the meeting he and his fellow central bankers will have Tuesday.

Financial markets are counting on Bernanke to use his creativity and guile to chart a course for the central bank that will reassure markets pleading for a rate cut without spooking investors that a recession is at hand.

The Fed is expected to ease policy but also take further action to signal the availability of liquidity to markets through a further reduction in its discount rate.

"These decisions are far from open-and-shut, in the minds of either the FOMC or market participants," said Jan Hatzius, chief economist at Goldman Sachs.

The meeting is the most important one that Bernanke has chaired since he took office nearly 20 months ago, Hatzius said.

Most economists think the central bank will cut by a quarter-percentage point to 5.0%, but some are attracted to the somewhat strong move of a half-percentage point.

"While the arguments favoring a bold move are compelling, we believe the chances of a 25 basis point cut carry a higher probability," said Michael Moran, chief economist at Daiwa Securities America Inc., in a note to clients.

Moran gives three reasons for a smaller move. First is concern about the appearance of the Fed being too quick to protect lenders and investors; second are doubts that the economy will weaken sharply and last is nervousness about inflation.

The August unemployment report was the only really weak economic indicator to date.

"There is no evidence that the wheels are coming off the wagon of growth so the Fed will probably only cut rates by 25 basis points," said Robert Brusca, chief economist at FAO Economics.

Bernanke told the financial markets in a speech that the Fed would pay close attention to the "timeliest" economic indicators and anecdotal reports to gauge the turmoil in credit markets on the economy.

Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi, said another argument against a half-point rate cut is the fact that the recent financial turmoil does not include stocks.

After all the volatility in the markets the last month, the Dow Jones Industrial Average last Friday was still up 7.9% year-to-date.

Rupkey said a 50 basis point cut might also set off expectations that the Fed will move by a half-point at the next FOMC meeting on Oct. 30-31.

But several economists are leaning in the direction of a half-point rate cut on Tuesday.

"The case can easily be made that a 50 basis point cut would be well justified," said Avery Shenfeld, senior economist at CIBC World Markets.

"The 25-basis point move will still leave most money market rates above where they were prior to August, including the 3-month LIBOR rate off of which most floating rates are set. It is going to take at least 50 basis points to stop the bleeding there, and likely something like 100 basis points to actually provide a more stimulative environment than existed in credit markets prior to August," Shenfeld said.

Hatzius of Goldman Sachs also thinks the Fed will cut the funds rate target by a half a percentage point.

The odd man out is Scott Anderson, senior economist at Wells Fargo Economics.

Anderson argues that the Fed should not lower the Fed funds rate, but said they will just for the "psychological effects it could have on financial markets."

"A Fed Funds cut will not bring back the U.S. housing market. A Fed Funds cut will not bring back the commercial paper market," Anderson said.

If the housing market remains depressed, the markets "will ask for another rate cut, and another, and another, and another...and then what?" he asked.

"However, our confidence in this call versus smaller moves is low," he said.

Stephen Gallagher, economist at Societe Generale, said it would be foolish to be overly confident in forecasting any particular outcome.

"Options are numerous," Gallagher said.

(END) Dow Jones Newswires

September 17, 2007 16:47 ET (20:47 GMT)


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