Fed optimistic it has bought time and can avoid rate cut

By Mark Felsenthal
Reuters
Wednesday, August 22, 2007

http://www.reuters.com/article/ousiv/idUSN2234990120070822

WASHINGTON -- The Federal Reserve is hopeful that it has bought enough time with moves to soothe jittery credit markets to hold off any cut to the benchmark federal funds rate before a September meeting, if any easing is necessary at all.

Fed officials are cautiously optimistic that trimming the discount rate by a half-percentage point on Friday and acknowledging heightened risks to growth have begun to ease some of the problems in credit markets.

Stable stock prices and a pickup in jumbo mortgage issuance are evidence conditions may be improving, said Fed sources, who spoke on condition that they not be quoted directly.

The move came after a crisis in credit markets unleashed by a surge in defaults among holders of subprime mortgages. The Fed a week earlier vowed to provide liquidity to markets and backed up its pledge with cash infusions.

The inflation-wary Fed's hope initially is to use tools that will restore credit flows without taking a step that would provide an economic stimulus before it knows for sure the credit crunch has hurt growth, analysts said.

"The Fed is trying to keep separate the liquidity-enhancing measures and buying time so it doesn't have to make an inter-meeting move," said Laurence Meyer, an economic forecaster and former Fed governor.

At its next meeting, on September 18, the Fed will be able to see whether market turmoil, tighter credit, and greater uncertainty have spilled over in a way that crimps economic activity, Meyer said.

If growth appears to be taking a hit, the Fed would feel justified in cutting the fed funds rate at that time, he said.

In the meantime, unless there is a marked decline in liquidity, the Fed would seek to avoid startling markets with an inter-meeting fed funds rate cut.

"In the absence of some clear rate-cut trigger in the economic data or in current market conditions, the inevitable suspicions arising from a surprise move might undermine the liquidity of weaker borrowers," economists at Wrightson ICAP wrote this week.

Data published in early September on the job market, economic conditions in each of the Fed districts, and services and manufacturing industries will help policy-makers calibrate their economic forecasts. But those reports won't provide a complete picture of how significantly August's market turbulence roiled the rest of the economy.

In a sign banks are responding to the Fed's discount rate cut, Bank of America, J.P. Morgan Chase, Wachovia, and Citigroup announced that they had each borrowed $500 million from the facility.

That contrasts with daily borrowings last week averaging just $11 million a day.

Besides direct borrowing, the Fed's cut to the discount rate could assist credit conditions by providing an incentive for banks to engage in other activity, Fed sources and analysts said.

The Fed "could start to see that market become more liquid and banks not taking advantage of that offer, and that could happen because banks know that backstop is there," said Julia Coronado, an economist with Barclays Capital and a former Fed staffer.

More information about the state of credit markets will be available when the Fed provides data on commercial paper outstanding at the close of business on Wednesday.

In the meantime, the Fed's actions last week have sharply boosted expectations of a cut in the federal funds rate next month.

Most economists polled by Reuters from August 20-22 believe the Fed will cut the fed funds rate by the September meeting. Median forecasts show the policy-setting Federal Open Market Committee easing rates to 5 percent next month and by another quarter-percentage point to 4.75 percent by year-end.

Stocks were up and bond prices slipped on Wednesday, as markets debated how soon Fed rate cuts might come, if at all.

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