Fed seems poised to lower interest rates again Tuesday

By Jeannine Aversa
Associated Press
via Yahoo News
Sunday, December 9, 2007

http://news.yahoo.com/s/ap/20071209/ap_on_go_ot/fed_interest_rates;_ylt=...

WASHINGTON -- What a difference in economic conditions since the Federal Reserve last met in October. Credit has become harder to obtain, Wall Street has convulsed again and the housing slump has intensified. And policymakers at the central bank now appear to have changed their minds about the need to drop interest rates again.

Twice the Fed had cut rates this year and officials suggested in October that might be enough for the year to help the economy survive all that stress. Then the problems snowballed, leading Fed Chairman Ben Bernanke to sign that one more cut might be needed.

Analysts expect the Fed to trim its key rate, now at 4.5 percent, by one-quarter of a percentage point at the meeting Tuesday. Some even speculate about the possibility of a half-point cut.

Banks, financial companies and other investors who made loans to people with spotty credit or put money into securities backed by those subprime mortgages have lost billions of dollars. Investors in the U.S. and abroad have grown more wary of buying new debt, thereby aggravating the credit crunch.

All this has added to the turmoil on Wall Street, and Bernanke and other Fed officials say they must take it into account when deciding their next move.

But does lowering rates mean the Fed essentially is bailing out investors or encouraging more sloppy decision-making? In other words, what exactly is the Fed's job?

Bernanke and other Fed officials say it is to make policy that keeps the economy growing and inflation low, a stable climate that benefits individuals, businesses and investors. The Fed also has a responsibility to ensure the banking system is sound and financial markets run smoothly.

"There is a link between Wall Street and Main Street. The Fed is taking the right actions, but they should be careful," said Victor Li, an economics professor at the Villanova School of Business.

The fear among economists is that the negative forces rattling investors could spread, forcing consumers and businesses to restrain spending and investment. While the odds of a recession have grown, Fed officials, the Bush administration and most economists are hopeful the country can tackle the problems and avoid that fate.

"The Federal Reserve is following the evolution of financial conditions carefully, with particular attention to the question of how strains in financial markets might affect the broader economy," Bernanke said in a recent speech where he opened the door to a further rate cut.

Bernanke has said the Fed's job is not to bail out investors who made bad decisions, but to do what is best for the economy. The central bank, however, cannot operate in a vacuum, he has said.

William Poole, president of the Federal Reserve Bank of St. Louis, puts it more bluntly.

"The Fed does not have the desire or tools to prevent widespread losses in a particular sector, but should not sit by while a financial upset becomes a financial calamity affecting the entire economy," Poole said recently. "It makes no sense to let the economy suffer from continuing declines in stock prices for the purpose of 'teaching stock market speculators a lesson,'" he added.

Janet Yellen, president of the Federal Reserve Bank of San Francisco, said "we face a risk that the problems in the housing market could spill over" and sap consumer spending "in a bigger way" than anticipated.

A scholar of the Great Depression, Bernanke has written extensively on the country's worst economic catastrophe. Flawed monetary policy in the United States and abroad was a major factor, he believes.

Bernanke's "about-face on a December rate cut is motivated by the fear of collateral damage from the train wreck affecting everything that touches subprime mortgages," said Stuart Hoffman, chief economist at PNC Financial Services Group.

The situation poses the biggest challenge yet to Bernanke, who took over the Fed in February 2006. Some analysts have questioned whether he waited too long to cut the Fed's key rate and whether he has acted aggressively enough to the nation's economic woes.

In mid-August, the Fed lowered its lending rate to banks. In September, the central bank it dropped its key rate, the federal funds rate, for the first time in four years. Then it was a half-point drop; on Oct. 31 came a quarter-point cut.

The funds rate is the interest that banks charge each other on overnight loans. This rate influences many other interest rates charged to consumers and businesses. It is the Fed's most potent tool for influencing national economic activity.

If the Fed cuts the funds rate again, commercial banks would lower their prime lending rate -- now at 7.5 percent -- by a corresponding amount. The prime rate applies to certain credit cards, home equity lines of credit and other loans.

The rationale behind the lower rates is that they will induce consumers and businesses boost spending, energizing economic activity.

From July through September, the economy logged its best growth in four years. But it is expected to slow to a pace of just 1.5 percent or less over the final three months of the year. Even so, important shock absorbers for the economy -- job creation and wage growth -- are holding up. The unemployment rate in November held steady at a relatively low 4.7 percent for the third straight month.

Oil prices, which had neared $100 a barrel, have moderated. But they are still high. High energy prices are a double-edged sword. They can slow economic activity and spread inflation if they cause the prices of lots of other goods and services to rise.

Bernanke's predecessor at the Fed, Alan Greenspan, has been criticized for holding interest rates too low for too long following the 2001 recession. Those low rates have been blamed for feeding a five-year housing boom. That boom eventually turned to bust as interest rates moved higher to combat inflation. Harder-to-get credit has thwarted would-be home buyers, intensifying the housing collapse. Foreclosures have soared to record highs. The number of unsold homes have piled up. Problems are expected to persist well into next year.

* * *

GATA is a civil rights and educational organization based in the United States and tax-exempt under the U.S. Internal Revenue Code. Its e-mail dispatches are free, and you can subscribe at http://www.gata.org/. GATA is grateful for financial contributions, which are federally tax-deductible in the United States.