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THE FED: An Ounce Of Prevention Expected From Fed Policymakers

By Greg Robb

WASHINGTON (Dow Jones) -- The Federal Reserve is set next week to take out an ounce of prevention, in the form of a cut in its target federal funds rate, to try to avoid having to rush in with a pound of cure.

The latter would be required if the drag on U.S. economic growth from the weak housing market, the mortgage market's credit crunch and the recent turmoil in the financial markets turn out to be severe.

Market economists believe the central bank will cut the fed funds rate cautiously, by a quarter of a percentage point, to 5% next Tuesday. This would be the first rate cut since June 2003.

Among Fed watchers, prospects for a rate cut are seen as a virtual certainty.

"The only argument left for not easing is the moral hazard argument, but that ship has sailed," said Mark Zandi, chief economist at Moody's Economy.com.

In economics jargon, a "moral hazard" is the possibility that bailing out investors who made bad bets will only encourage more imprudent investments in the future because investors will assume that they'll always be protected.

But the Fed now has evidence that the economy is slowing in the form of the August unemployment report, which showed a 4,000 decline in nonfarm payrolls -- the first drop since 2003.

Economists are slashing their forecasts for growth in coming quarters.

Telegraphing future cuts?

"Paced by a deeper and longer housing recession, we now expect that U.S. growth will average just 2% over the next six quarters," said Richard Berner, economist at Morgan Stanley & Co. This compares to his forecast of 2.6% just one month ago, he said.

Many economists believe it's possible that the Fed will cut the fed fund target by half a percentage point, to 4.75%. But the difference is not as substantial as it appears, because even analysts expecting a quarter-point cut believe the Fed will signal in its statement Tuesday that it will continue to slash rates in coming months.

One quarter-point won't bring the Fed to where it needs to be, many economists say. "The Fed is in the wrong zip code," said Jim Glassman, economist at J.P. Morgan Chase.

"It will take several moves for them to offset the bite coming from the credit crunch as well as to cushion the economy that is in more danger from housing," Glassman said.

Economists generally expect a series of rate cuts, with the fed funds rate pegged at 4.5% by the end of the year.

Discount rate cut also seen

The Fed is expected to accompany the cut in the fed funds target rate with a further reduction in the discount lending rate, in an effort to ease the stress in financial markets.

On Aug. 17, the Fed lowered its discount lending rate by half a percentage point, to 5.75%, and took a series of steps to encourage banks to borrow from the facility to ease a credit crunch.

So far, relatively few banks have taken advantage of the Fed's offer, although borrowing in the most recent week was the largest since the terror attacks in September 2001 at $7.2 billion on Wednesday.

Borrowing from the discount window has been rare except during extraordinary times.

Economists said banks still seem reluctant to use the facility because such loans from the Fed typically carry a stigma: That is, market participants assume that only a desperate situation would compel a bank to use the lender of last resort.

"I bet they do something. They tried a whole bunch of things and then stopped. Maybe what they've decided to do was put it together as one big package and hope it has a bigger noise," Glassman said.

Some speculate that the Fed might cut its discount rate by a half a percentage point to 5.25%, thereby reducing the spread between the discount rate and the fed funds rate from 50 basis points currently to 25 basis points.

But Lou Crandall, chief economist at Wrightson ICAP, said he expects the Fed to trim the discount rate and fed funds by a quarter of a percentage point each. Fed policymakers think the half-point spread is important because the Fed wants banks to look for market funding first, he said.

Unprecedented environment

The Fed is making these moves in order to get ahead of a financial crisis that some economists believe is unprecedented.

"The credit-market storm is a far more dangerous thing that anything we've seen in memory," Glassman said.

"When credit just shuts down, we don't know what that does to real activity -- it's not an orderly, rational thing that is happening," Glassman said.

Economists said no one should dismiss the possibility of a recession.

The link between the financial system's problems and the economy is the cost and availability of capital.

"The cost of credit is higher and the availability of credit is lower. There is arguably a credit crunch in the residential mortgage market, which is going to lead to fewer sales and a lot more foreclosures, which ultimately mean a lot less construction and a lot lower home prices," Zandi said.

This, in turn, will hit consumer spending and business investment, he said.

At bottom, economists believe the financial markets' turmoil will restrict the ability of banks to provide credit to businesses and consumers.

Zandi noted that banks are very involved in residential real estate. "That is going to show up in coming weeks," he said, referring to quarterly financial reports due for release in the coming month.

As a result, many loans and specialized investments might end up coming back on the banks' balance sheets.

"Banks won't have ability to go on doing other sorts of commercial lending," said Harvard University economist Martin Feldstein in a television interview.

"The [banking] system is well capitalized. But there may be an institution or two or three that is not capitalized well enough," Zandi said.

Recession odds

Zandi said Economy.com's indicator of recession jumped to just about 40% in August from 12% in July.

"That is the highest probability of recession since the last recession in 2001," he said.

"I think there is high likelihood we'll have a recession," said Paul Kasriel, chief of economic research at Northern Trust in Chicago.

Kasriel pointed to his own favorite indicator of recession -- when the spread between the yield on the 10-year Treasury note and the fed funds rate turns negative and when there is also a year-over-year contraction in the Fed's monetary base adjusted for inflation.

"It has predicted every recession since 1970, and it has not predicted any that didn't occur, and it is predicting one right now,"' Kasriel said.

(END) Dow Jones Newswires

September 14, 2007 14:58 ET (18:58 GMT)


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