Fed poised to cut rates; may take a break after that
Fed Chairman Ben Bernanke and his colleagues are walking a tightrope. They are trying to shore up economic growth and at the same time they are mindful that they can’t let inflation get out of hand. It’s a bit of an economic dilemma: The very rate reductions the Fed depends on to energize the economy can also sow the seeds of inflation down the road.
“It’s a very challenging environment,” said John Silvia, chief economist at Wachovia.
In a nod to those conflicting forces, the Fed probably will opt for a moderate-sized rate reduction of one-quarter percentage point this week, Silvia and other economists predict.
At its previous meeting on March 18, the Fed slashed rates by a hefty three-quarters point. The action, however, drew opposition from two Fed members who favored a smaller reduction because of concerns about a potential inflation flare-up. It was a crack in the mostly unified front the Fed often shows the public.
The Fed, which has been cutting rates since last September, turned more forceful in January and March, when housing, credit and financial problems took a turn for the worse, threatening to plunge the country into a deep recession. The Fed’s rate cuts in January and March alone marked the most aggressive Fed intervention in a quarter-century.
This time around, though, the Fed is likely to go with a smaller rate cut at the end of its two-day meeting on Wednesday.
A quarter-point reduction would drop the Fed’s key rate for influencing national economic activity to 2 percent. This rate, called the federal funds rate, is what banks charge each other on overnight loans and affects a wide range of interest rates charged to people and businesses.
In turn, the prime lending rate for millions of consumers and businesses would fall by a corresponding amount, to 5 percent. The prime rate applies to certain credit cards, home equity lines of credit and other loans. Both rates would be the lowest since late 2004.
Economists think the Fed may be inclined to leave rates at such low levels possibly through the rest of this year and maybe into next year — as long as the country is not hit with another blow to economic growth.
“We are entering the stage where it is time for the Fed to wind down and move to the sidelines,” said Greg McBride, senior financial analyst at Bankrate.com. “A quarter-point reduction is a nice segue to that transition. Short-term interest rates could stay low longer than many currently expect,” he added.
The Fed’s rate cuts — which take months to work their way through the economy and affect activity — along with the government’s $168 billion stimulus package of tax rebates for people and tax breaks for businesses — should help strengthen the economy in the second half of this year, Fed officials said.
It’s the first half of this year where damage from the housing, credit and financial debacles could be the worst. The economy may grow little, if at all, during this period and could actually shrink, Bernanke told Congress earlier this month. A recession, he said, was possible. It was Bernanke’s first public acknowledgment of such a scenario.
A growing number of economists now believe the economy probably will contract in the current April-to-June quarter. Many analysts also now think the economy will manage to eke out a barely noticeable 0.4 percent growth rate during the first three months of this year as opposed to falling into negative territory as some had previously thought. The government reports on the first quarter’s performance on Wednesday — the same day the Fed’s decides its next move on interest rates.
Even if the economy heals in the second half of this year and into 2009, the unemployment rate, now at 5.1 percent, is likely to rise, perhaps reaching close to 6 percent early next year, analysts said. Job losses for the first three months of this year neared the staggering quarter-million mark.
The Fed’s rate cuts ordered thus far would help to cushion the fallout.
On inflation, Bernanke said rising prices are a source of concern and must be monitored closely. Still, he is hopeful inflation will moderate in coming quarters.
Gasoline prices have shot up to record highs in recent days and could hit $4 a gallon this summer. Food prices are up 5.3 percent on an annualized basis in the first three months of this year, outpacing the 3.1 percent rise in overall inflation.
If the Fed does drop its key rate to 2 percent and holds it there for some time, that would still be low enough to provide relief to stressed homeowners facing a rate reset to their adjustable-rate mortgages, McBride said.
Trying to get the economy back to full throttle after its last recession in 2001, the Fed ratcheted down its key rate to 1 percent — the lowest in more than four decades. Then-chairman Alan Greenspan held the rate at that super-low level for a year, before the Fed began to bump it up. That action has since fueled criticism that Greenspan helped to create the very housing boom that has now gone bust, wreaking havoc on the economy. Foreclosures have surged to record highs, financial companies have wracked up multibillion losses and all the fallout has sent the economy reeling.
Even as economists predict the Fed is likely to wind down its rate-cutting campaign this year, they said the Fed would lower rates again if there were worrisome signs that the economy was faltering even more than expected.
“If the news is unremittingly bad, it will go down again. So the Fed has got plenty of ammunition if its needs it. But my guess is this will be about it,” said Bill Cheney, chief economist at John Hancock Financial Services.