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Expectations grow for another interest rate cut by Fed

Section: Daily Dispatches

Will the Fed's Cut Restore Calm, Saving Economy?

Most Economists Say Benanke and Fed Have More Work to Do

By Rex Nutting
Friday, August 17, 2007

WASHINGTON -- The Federal Reserve took a bold step Friday in cutting the discount rate and offering to be the lender of last resort to a shaky financial system, but most observers on Wall Street think the Fed has more work to do to comfort shaky financial markets and prevent more serious problems from developing in the economy.

Despite the Fed's emergency half-step on Friday, financial markets and Fed watchers still expect the Fed to cut the more-important federal funds target rate at its Sept. 18 meeting because the Fed didn't address the underlying weakness in the housing market or the economy.

Fed Chairman Ben Bernanke tried to maximize the psychological impact of the discount-rate cut by signaling that the Fed is prepared to act again if needed, wrote Lou Crandall, chief economist for Wrightson ICAP.

That helped boost the stock market at the opening bell Friday, and reduced the panicky flight-to-quality trades in the fixed-income market. "So far, so good," said Stephen Stanley, chief economist for RBS Greenwich Capital.

"The worst is now over in financial markets," wrote Sherry Cooper, chief economist for BMO Nesbitt Burns. "These Fed actions show that Bernanke, like his predecessor, is willing to temporarily ignore his inflation objectives to offset a credit crunch."

"This should leave no doubt in people's minds that the Fed stands ready to backstop the system," said Maury Harris, chief U.S. economist for UBS.

Some traders were skeptical about the medium-term impact on the market once the initial buzz wears off. "I don't buy this rally at all," said Zachary Oxman, senior trader for Managed Futures. "I believe you're seeing a short-covering, temporary bounce. I think this is a speculative bump and a rookie open, and I'd be very surprised to see the market take a rally this large into the weekend."

The Fed's actions were more than a psychological pep talk to the markets, wrote David Greenlaw, an economist for Morgan Stanley. By extending the term of discount window loans to 30 days, the Fed created an alternative source of short-term funding for banks, corporations and fund managers.

"It's conceivable that the Fed's actions today could go a long way toward restoring liquidity to the markets," Greenlaw said.

George Bory, chief global credit strategist at UBS, said the move should help ease the credit crunch. "I think from a credit perspective this is a big step in the right direction. It really should break the liquidity gridlock that we've been staring into for the past several weeks and hopefully it's going to help to restore some confidence in the credit markets and, in particular, in the banking system."

With the commercial paper market essentially drying up in the past week, the Fed's discount window could serve as a kind of safety net for those who need cash for operations or to meet margin calls, said Tony Crescenzi, chief bond market strategist for Miller Tabak & Co.

However, borrowing from the discount window is no panacea, Crescenzi said, calling for a full-fledged rate cut. The discount window is rarely used because there's still a stigma attached to using it. No bank wants to acknowledge that it's not solvent enough or credit-worthy enough to obtain the funds it needs on the market.

"It definitely changes the mood, but it doesn't fix the problem," said Owen Fitzpatrick, head of U.S. equity group at Deutsche Bank. "Challenges in credit markets and subprime markets remain. We have to see what additional fallout there is from hedge funds or institutions trying to come to the market for liquidity."

The Fed move "cannot fix the subprime mortgage business for financials, it cannot fix the collateralized debt obligation business and the unwinding and the de-levering of the leveraged credit, and it cannot alleviate some of this asset-backed paper gone bad," said UBS U.S. financials analyst Glenn Schorr.

Most of the economists we surveyed think the Fed will cut its federal funds target rate at the September meeting or perhaps sooner. The FOMC's statement that it "is prepared to act as needed" is an explicit signal that a cut before Sept. 18 is not out of the question.

It will all depend on what happens in the credit markets over the next weeks and months, said Stanley, the Greenwich Capital economist. "Whether the Fed cuts the funds rate or not will be determined by how bad market conditions get -- period, end of story."

But others say the economic situation is worsening enough to justify lower rates from the Fed, regardless of whether credit markets recover. In its statement Friday, the FOMC acknowledged that the risks of slower growth had increased.

"If the Fed does cut, it will be rooted ultimately in the collapse of the U.S. housing market, which we have consistently emphasized as the main force driving the U.S. slowdown," wrote Goldman Sachs economists in a note to clients.

"Even if the current financial distress subsides quickly, the downturn in the housing market still has a long way to run," Goldman economists said.

Some economists believe the Fed won't have to cut the federal funds rate.

"This should provide confidence and allow liquidity to flow to mortgage financing and we do not think that the market will require another cut from the Fed," wrote John Ryding, chief economist for Bear Stearns, in an email.

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