Federal Reserve May Cut Rates In Wake Of Financial Crisis

(RTTNews) - In the wake of somewhat tame inflation numbers coupled with a serious financial market disruption, the Federal Reserve is facing a different scenario than they did at their August meeting. Although inflation remains a concern, many analysts believe the key issue is the slowing economic growth in the face the turmoil in the financial markets.

In a note, Zach Pandl of Lehman Brothers said that the August consumer price data opens the door to a rate cut. The report showed a modest decrease in prices that came in line with economist estimates, reflecting a steep drop in energy prices.

The Labor Department said its consumer price index edged down 0.1 percent in August after an unrevised 0.8 percent increase in July. The modest decrease in consumer prices matched economist estimates.

A steep drop in energy prices contributed to the modest decrease in consumer prices, with energy prices falling by 3.1 percent after showing notable increases in each of the three previous months. The drop in energy prices was largely due to a 4.2 percent decrease in gasoline prices.

The report also showed that the core consumer price index, which excludes food and energy prices, rose 0.2 percent in August after rising 0.3 percent in July.

"We believe today's tame core reading as well as ongoing turmoil in financial markets will prompt the Fed to resume cutting interest rates," Pandl said in his note.

Meanwhile, James O'Sullivan of UBS predicts that there will be a 50 basis point cut in the funds rate, slashing the 2 percent key interest rate to a low 1.5 percent.

O'Sullivan noted that the bankruptcy of Lehman Brothers (LEH | Quote | Chart | News | PowerRating) and the sale of Merrill Lynch (MER | Quote | Chart | News | PowerRating) to Bank of America (BAC | Quote | Chart | News | PowerRating) makes the outcome "highly uncertain," although he said that the news combined with the continued economic downturn and Monday's jaw dropping plunge in the stock market have resulted in the odds being in favor of a rate cut.

This lean towards a rate cut represents a shift from UBS's earlier prediction of no change. They also expect a significantly more dovish statement and the 50 basis point cut over a more "token" 25 basis point cut.

Although there is a shift towards a rate cut this morning, the general consensus remains that the Fed will keep its benchmark rate steady at 2 percent. However, with unemployment at 6.1 percent and the Dow at a 2-year low, the scenario is far removed from a few months ago, when high energy prices were putting pressure on inflation and many experts - including some within the Fed itself - were lobbying for higher rates.

Josh Bivens of the Economic Policy Institute predicts that the Federal Reserve will keep rates stable. However, in the face of declining oil prices, Bivens told RTTNews, "I would actually cut them at this point."

"Inflation fears were always a little overstated," he said. "To me the thing to worry about is that we're going to have a very soft economy for the next year," he added, predicting that GDP would come in at below 1.5 percent for the next year.

Separately, Global Insight Chief U.S. Financial Economist Brian Bethune said in a note Monday that the collapse of Lehman Brothers highlighted the need for intervention by the Fed.

"The bankruptcy of Lehman Brothers will put further deflationary pressure on financial markets and the economy at a time when such pressure can be ill-afforded," Bethune said. "While the large loan program announced by major global banks today may help ease the shock, we should not delude ourselves into thinking that without a significant move from the Fed there will not be further tightening of credit conditions as a result of the events over the weekend."

"That will threaten the economy and the financial system even further," he added.

Calling the economy "weak," Bethune stressed the need for an "aggressive response from the Fed" in the form of a rate cut.

Meanwhile, Wachovia Securities does not believe that the Fed will be moved by the financial market's plight, at least at this juncture. The firm highlighted the Fed's willingness to address the current credit and economic difficulties through an expanded discount window and credit facilities rather than through a cut in interest rates.

Late Sunday, the Fed announced that it is broadening the collateral eligible to be pledged at the Primary Dealer Credit Facility to include securities other than the originally allowed investment-grade debt securities. Additionally, the Fed also expanded the collateral for Schedule 2 auctions of the Term Securities Lending Facility-TSLF to include all investment-grade debt securities.

Even if the Fed does not reduce rates at its September meeting, there is a possibility that it could signal a inter-meeting reduction by saying that the central bank will closely monitor developments and will act as needed.

The economy is flailing and is teetering on the brink of a recession, as consumer spending is poised to record negative growth due to weak real disposable income. Additionally, lower corporate profits are cutting into business spending.

Will the Fed still hold firm to its mantra that it is willing to accept below-trend growth for a sustained period while inflation holds above the upper end of its tolerance zone? The present day scenario is supposed to have been the upshot of the very loose monetary policy that was seen in the past, when rates were around 1 percent.

The Fed may also be restrained by the fact that the current turmoil is largely a sector-specific issue plaguing the financial sector that could be addressed by using more targeted tools, rather than a broader macro economic crisis where the use of the main policy tool, namely the fed funds futures rate, may be warranted. However, there can be arguments that the financial market crisis could expand into a broader economic crisis, given the weakening economic fundamentals over the past year.

The Federal Reserve's industrial production report for August showed a 1.1 percent drop in output, primarily due to an 11.9 percent decline in motor vehicle output. The output of utilities was down 3.2 percent.

The softness in auto production was believed to be the result of manufacturers bringing down output in-line with the waning demand. Production declines were also reported at industries manufacturing capital goods. To make matters worse, capacity utilization also fell sharply.

The non-farm sector has been losing jobs for each of the past eight months and cumulatively, the sector has lost 605,000 jobs. The unemployment rate surged to 6.1 percent in August, matching the levels of September 2003. Auto and monthly chain retail sales for August also came in much weaker than expected, raising questions about the healthy picture painted by the second quarter GDP report.

Thus far, exports have served as a pillar of strength for the economy despite most other sectors showing significant weakness. Stronger global growth, which supported export demand helped in the narrowing of the trade deficit.

Consumers, who drive two-thirds of the economic activity in the U.S., are showing a lack of ability and willingness to kick-start the economy, given the rising unemployment levels and waning confidence. Construction spending, specifically commercial construction spending, as well as business fixed investments are also expected to slow down.

A Commerce Department report released last week showed that retail sales fell 0.3 percent in August and were down 0.7 percent, excluding the volatile motor vehicles. Sales at building material stores, electronics stores, department stores and clothing stores showed declines.

Parsing the report, Wachovia Securities commented that consumer spending will almost certainly decline in the third quarter and could spell trouble this holiday selling season. Going by the trends in the back-to-school season, the firm predicts an annualized 1 percent drop in consumer spending in the first quarter and a flat to 2 percent increase in retail sales during the holiday selling season.

Whatever happens to the fed funds futures rate, the post-meeting policy statement is likely to be more dovish than the last statement. The August meeting's statement relayed a balanced outlook on growth and inflation, but it did not provide much clarity on the future rate outlook.

On growth, the Fed noted then that economic activity expanded in the second quarter, partly reflecting growth in consumer spending and exports. That said, the central bank retained its comments that labor markets have softened further and remain under considerable stress, while it also repeated its comments that tight credit conditions, housing and energy prices will weigh on growth over the next few quarters.

Compared to the June statement, the FOMC shifted up the positioning of the phrase, "Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth."

The Committee left out the part on its belief that the monetary policy easing along with its ongoing liquidity boosting measures should help to promote moderate growth over time. Meanwhile, the Fed modified the statement on perceived risk to "Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee."

UBS expects the September meeting's statement to highlight the increased uncertainty and increased downside risks as a result of the turmoil and the likely associated restriction of credit.

Meanwhile, the central banks of other nations have taken note of the developments. The People's Bank of China announced on Monday that it is reducing its 1-year lending rates by 27 basis points to 7.20 percent, effective September 16th.

The reserve requirement ratio was also lowered by 100 basis points for smaller banks and 200 basis points for banks operating within the proximity of the earthquake affected areas. The action reflects the Chinese government's pessimistic assessment about global growth.

The Australian and the New Zealand central banks, which had some of the highest interest rates among industrialized nations, have begun to slash rates in response to weak growth. The Reserve Bank of Australia reduced rates by 25 basis points in September to 7 percent, with the minutes of the meeting released today signaling that more cuts could be expected at its October meeting.

The Reserve Bank of New Zealand lowered rates by 25 basis points in July and by another 50 points in September, as a result of which the benchmark interest rates are now at 7.50 percent. In Japan, the uncollateralized overnight rate is currently at 0.50 percent, the same level at which it has been since the central bank raised it by 25 basis points at its February 2007 meeting.

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