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Fed considers rate cut as recession fears mount

Section: Daily Dispatches

By Sudeep Reddy, Jon Hilsenrath, and Timothy Aeppel
The Wall Street Journal
Thursday, October 2, 2008

Federal Reserve officials are weighing further interest-rate cuts, even if Congress passes a $700 billion rescue plan, in the face of a deteriorating economic outlook and severely strained financial conditions.

The Fed's willingness to consider additional cuts marks a turnaround from the past few months, when soaring food and energy prices turned its attention to inflation risks. At a regular September meeting, after oil prices had receded, officials still declined to move the central bank's federal-funds target rate from 2%.

A reduction in rates is still far from certain, in part because of inflation worries. But in just the past few weeks, as the credit crisis pummeled the financial system, economic data have become steadily worse, raising fears of a recession.

The latest signals were abundant Wednesday.

Auto makers were hammered in September by tight credit conditions and lower consumer demand. Monthly car and light-truck sales were the worst since April 1992, with both Toyota Motor Corp. and Ford Motor Co. posting sales declines of more than 30% from a year ago.

Manufacturing also lurched downward in September. The Institute for Supply Management's monthly gauge of the sector dropped to its lowest since October 2001. The index fell to 43.5 in September from 49.9 in August. Figures below 50 indicate a contraction for the sector, and the latest level generally corresponds to overall economic growth of about 0.8% a year, the ISM said.

"Manufacturing had avoided much of the decline that we'd seen brought on by the financial-services sector," said Norbert Ore, a Georgia-Pacific Corp. executive who directs the ISM's survey of purchasing managers. "This month really was a big break in trend."

Meanwhile, a report on construction spending showed that commercial building activity slowed in August, adding to weakness in the residential sector. Global indicators of growth have also softened noticeably.

Taken together, the risk of a severe recession -- known as a "tail risk" because its likelihood is small but its effect would be catastrophic -- has appeared to re-emerge in recent weeks. Earlier this year, Fed officials had believed such a threat had dissipated.

... 'Grave Threats'

Fed Chairman Ben Bernanke last week warned lawmakers of "grave threats to financial stability," and suggested the financial damage so far -- even with a rescue bill -- would hit the overall economy. "There have been very few cases where you've had this kind of financial disruption without a significant effect on the economy," he said.

Futures markets on Wednesday priced for a high probability of a quarter or half percentage point cut in the federal-funds rate, at which banks lend to each other overnight, by the end of October.

Other central banks could end up moving in the same direction, though it still looks unlikely that they would do it in a coordinated manner. The European Central Bank meets Thursday. Officials there have been resistant to cutting rates due to their singular mandate to hold inflation down.

Fed officials have also been wary of further easing rates for fear that they could reignite inflation. More rate cuts run the risk of weakening the dollar and pushing crude-oil prices up again, making conditions harder on households. But recent improvement in both areas has been a rare bright spot amid otherwise bad news, from declining jobs to slowing export growth.

Nymex crude oil futures fell $2.11 a barrel Wednesday, or 2.10%, to settle at $98.53.

If the Fed does decide to act, it has little incentive to do so until after Congress again votes on the rescue plan. By waiting, the Fed would have a chance to assess the bill's initial impact on credit markets, where interest rates have jumped because of the stresses of September. The Fed's rate-setting committee is scheduled to meet Oct. 28-29, though it occasionally takes action between meetings.

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