Fed Widely Expected to Cut Rates 50 Basis Points to 1.00%

It is widely expected that the Federal Reserve will cut the Fed funds rate by 50 basis points to 1.00% on Wednesday, the lowest level since June 2004. Fed watchers expect the vote to be unanimous and the accompanying statement to echo the "wait-and-see" approach seen in previous months.

The Federal Open Market Committee (FOMC) meeting follows the co-ordinated rate cut on Oct. 8, when six central banks all cut their respective target rates by 50 basis points.

A joint statement from the banks read: "Inflation expectations are diminishing and remain anchored to price stability. The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability."

As of Tuesday afternoon, Fed fund futures are pricing in a 56% chance of another 50 basis point cut, while the other 44% are looking for a 75 basis point cut.

Among economists, forecasts are less certain. Of the 65 economists polled by Bloomberg, 37 are calling for a half-point cut, 16 are looking for a quarter-point cut, and 11 are predicting the Fed will keep rates on hold at 1.50%. In contrast to the implied market probability, just a single economist is expecting a 75 basis point cut.

"This is the worst financial crisis to hit the markets since the Great Depression so returning the Fed funds rate quickly to the 2003 low following the 2001 recession appears appropriate," said Christopher Rupkey, chief financial economist at BTMU.

Economics strategist Millan Mulraine from TD Securities also expects the FOMC to cast a unanimous vote for a 50 basis point cut on Wednesday, with an accompanying statement that gives no bias but emphasizes "growing uncertainty surrounding the impact of the ongoing financial sector disruption on the real economy."

He said members of the Committee are unlikely to disagree with the prevailing decision, as a divided Federal Reserve would only exacerbate market turmoil. He also said the statement is likely to have a slightly dovish bias to imply that further action would be taken if warranted.

"We expect the Fed to remain coy on the actual bias for monetary policy going forward, though the statement should repeat its concerns about 'the downside risks to growth,' as it did in the October 8 decision. In general, we expect the tone of the statement to remain dovish, with both the economic and inflation assessment by the FOMC underscoring the growing economic slack, and its implications for further disinflation in the future," Mulraine said.

A 1% rate is often considered the floor by Fed watchers, who point out that the central bank has never set a target rate below that level. The last time the FOMC slashed the rate to 1% was in June 2003 under former Chairman Alan Greenspan - and the target stayed there for a year. However, the true floor is 0%, and some economists believe the Fed could consider cutting rates to that level, as Japan did in the 1990s.

"I think there's a risk they could go below 1% tomorrow, but they're unlikely to use all their bullets in one shot," said Rudy Narvas, a Fed watcher and macroeconomist at 4cast. Narvas is looking for a half-point cut, but said it is "a completely legitimate argument" to predict further cuts in the coming months.

"It would have to be under the premise that deflation is a concern, [but so far] we haven't had any indication of that," he added.

Narvas said the Fed would be wise to repeat the line from Sept. 16 that inflationary expectations are "highly uncertain," as the direction of commodity prices is unknown. While most measures of inflation have been trending downwards from their peaks in mid-summer, consumers' inflation expectations shot up to 6.9% in Tuesday's Conference Board report.

Narvas said that report is just a single month of data that contrasts with other, more reliable measures of expectations that are near all-time lows, so it is unlikely to hold the Fed back from cutting rates.

Mulraine added: "The reluctance by the Fed to cut the fed funds rate beyond 1.00% into unprecedented territory is palpable. However, with the distress in the financial crisis gravely impairing the effectiveness of the massive monetary stimulus being administered to the economy (along with the benign inflation outlook), further monetary easing cannot be categorically ruled out."

Since September 2007, the FOMC has cut rates by 375 basis points, in addition to massive measures to inject liquidity into markets.

By Patrick McGee and edited by Nancy Girgis
©CEP News Ltd. 2008