Fed seen cutting rates further to stave off downturn

The two-day meeting opening on Tuesday is likely to see heated debate on the economic outlook in view of a global stock market swoon and heightened recession fears that prompted the Fed to slash rates by 0.75 percentage points.

Last Tuesday's rate move placed the federal funds rate at 3.5 per cent, and was the fourth cut since September 18, when the rate was 5.25 per cent.

Although the cut was the biggest since the Fed began using the federal funds rate as its main policy tool in the 1990s, many analysts say the Federal Open Market Committee (FOMC) is likely to ease the rate further at its two-day meeting.

"Given the still-fragile state of the financial markets, it is difficult to imagine the policymakers skipping a rate cut," said Aneta Markowska at Societe Generale in New York.

The Fed's statement after the rate action last week "was very friendly for further rate cuts," said Joseph LaVorgna, senior economist at Deutsche Bank.

LaVorgna said the Fed used "fairly bold language, and it strongly suggests the Fed is going to trim rates further - and likely in increments larger than 25 basis points."

Many economists say another rate cut is likely, but that the panel headed by Ben Bernanke is mulling many options, ranging from no change in rates to another 75-basis-point cut.

Analysts say the Fed is erring on the side of easier money in view of the considerable risks facing the economy - the worst housing market decline in decades, massive losses by banks and troubles facing bond insurers that threaten to destabilize the financial system.

"Simultaneous and intertwined deterioration in the real and financial sectors is just the kind of combination that can throw a weakening economy into recession, particularly if that deterioration is manifest in a contagion-like roiling of global stock markets," said Lehman Brothers economist Paul Sheard.

Sheard said a recession is far from certain at this point but that the Fed is using all its ammunition to head off such an outcome.

"But the Fed is playing a high-stakes game," Sheard added.

"By moving between meetings and in response to what appeared to be shaping up as an equity market meltdown, and with only limited information on what was driving it, the Fed risks giving the impression that it is targeting equity prices and offering a 'Bernanke put,'" he said, referring to the notion that investors will get a bailout or "put option" even after making risky bets.

"It also risks signal-jamming the Fed's communications - now market volatility can be expected to trigger speculation of other inter-meeting moves and markets may become more endogenously volatile as a result," Sheard added.

Scott Brown, chief economist at Raymond James & Associates, said of the emergency move by the Fed on Tuesday: "A lot of people have described it as a panic, but I think it was a move designed to stop a panic in financial markets."

Brown said the Bernanke Fed has handled policy moves appropriately in view of the unpredictable economic environment.

"One of the things as economists we're not good at is determining psychology," Brown said.

"We read a lot about recession and if people believe it, it will become self-fulfilling. Businesses will stop investing and hiring, and that leads to recession."

Paul Ferley, senior economist at RBC Financial, said he expects another 50-basis-point cut by the panel this week "to deliver the message to financial markets that they are prepared to act to prevent this negative sentiment from continuing to deteriorate."

Additionally, Ferley said the FOMC will need to trim rates by another full percentage point to push the federal funds rate to 2.0 per cent.

He said the turbulence in financial markets has caused banks to retrench and investors to shun risk, and that this leads to higher borrowing costs for businesses and consumers.

"The longer this persists the more likely it is to have a macroeconomic impact," he said. (AFP)