How low will the Fed go? As the Federal Reserve was set to open a two-day meeting Tuesday, financial markets were banking on a half-point cut in the federal funds target to bring the rate to 1.0 percent, matching the lows of 2003 and 2004.
Some predicted the US central bank, which led a co-ordinated global rate cut earlier this month, could go even lower in effort to jump-start lending and ease a global credit crunch. The Federal Open Market Committee headed by chairman Ben Bernanke is expected to announce a decision around 1815 GMT Wednesday.
The futures market on Tuesday was pricing in a 54 percent chance of a half-point cut. Yet the market also saw a 46 percent chance of a deeper cut of 75 basis points that would leave the rate at a historic low of just 0.75 percent. Despite concerns about the low rates that fuelled the boom-and-bust housing cycle, analysts say the Fed has little choice but to remain aggressive to avert a serious economic calamity.
Augustine Faucher at Moody's Economy.com predicted a half-point cut on Wednesday followed by another half-point reduction in December to lower the funds rate to 0.5 percent, which would be the lowest level since the rate began in 1954. "The financial crisis has damaged the real economy. The US will be in recession until spring, and the US unemployment rate will peak somewhere near 7.5 percent in the middle of 2009," Faucher said.
"Further rate cuts would make it very inexpensive for banks to borrow from one another. The Fed is hoping that low rates, along with efforts to increase liquidity, will spur greater lending and borrowing, unfreezing credit markets." He said that the combination of Fed interest rate cuts, increased liquidity, and fiscal stimulus "will be enough to bring the economy out of recession in the second quarter of next year" but added that "the financial system remains on edge and worries about global recession continue to increase."
Yet analysts say the Fed move would be largely symbolic because the actual rate of overnight interbank loans is in fact well below the Fed target because of the extraordinary efforts to pump liquidity into a strained banking system. John Ryding at RDQ Economics said the Fed target rate is largely "irrelevant" during the current market turmoil, with the actual overnight rate since October 16 between 0.60 and 0.93 percent for these types of interbank loans.
At the same time, many consumer and business lending rates have remained high. The average mortgage rate last week was at 6.3 percent, according to Bankrate.com, above the level of earlier this year. With monetary policy unable to bring down these rates, the Fed may have to use additional tools such as buying long-term Treasury bonds in an effort to bring down the rates used as benchmarks for many loans. "The Fed isn't going to sit still while this outlook unfolds," said Scott Anderson, economist at Wells Fargo.
He expected the Fed to cut rates and "they could even follow that with direct purchases of longer-term Treasuries, corporate bonds or mortgage-backed securities if the Fed funds rate cuts don't do the trick of lowering the average interest rate on corporate and consumer borrowing."
The European Central Bank looked increasingly likely to follow suit with a cut of its own after chief Jean-Claude Trichet said Monday that another reduction was "possible" next month. The ECB cut its main lending rate by 0.50 percentage points to 3.75 percent on October 8 as part of rare concerted action by leading central banks including the Fed and counterparts in Canada, Sweden and Switzerland.
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