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Fed enters key meeting with no clear path

While many investors are expecting another aggressive interest rate cut from the Federal Reserve this week, another big cut is far from a sure bet, say former Fed officials.
“One can argue that the Fed ought to do more in this situation, and one could argue that they’ve done enough already," says former Fed official Alice Rivlin.
“One can argue that the Fed ought to do more in this situation, and one could argue that they’ve done enough already," says former Fed official Alice
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Just one week after an emergency three-quarter-point interest rate cut to calm jittery global financial markets, the Federal Reserve’s rate-setting committee sits down Tuesday to figure out its next move.

While many investors are expecting another aggressive interest rate cut — up to half a point — to help lift the economy out of the doldrums, another cut is far from a sure bet, according to some former members of the panel, known as the Federal Open Market Committee.

Last week’s dramatic move came as pressure had been building after a series of weak economic data suggested the economy might be heading into recession.  As global stock markets began to tank, the Fed took the unusual step of acting between regularly scheduled meetings of policymakers.

For the moment, the move appears to have calmed the markets. But it’s far from clear whether the time is right for deeper cuts, as some analysts are worried that an overly aggressive Fed could stoke inflation.

"This is an extraordinarily difficult situation. Uncertainty is very, very high," said Alice Rivlin, former Fed vice chair and now a senior fellow at the Brookings Institution. "One can argue that the Fed ought to do more in this situation, and one could argue that they’ve done enough already and they should start worrying about inflation."

The weakening economy has become the top issue on the campaign trail — and in the White House. In Monday night's State of the Union address, President Bush prodded Congress to adopt a $150 billion package of tax rebates for individuals and tax breaks for businesses, aimed at boosting the economy.

Tuesday's economic data didn't make the Fed's decision any easier. December durable goods orders were surprisingly strong, welcome news for the weakening economy. On the other hand, consumer confidence fell sharply in January. Also on Tuesday, the Standard & Poor’s/Case-Shiller 10-city composite home price index plunged by a record 8.4 percent.

Still, it’s not clear that the economy is headed for — or in — a recession. The Fed’s own forecast calls for slower growth in 2008 but stops short of projecting a recession, in which the economy would actually shrink. The Fed already has cut rates 1.75 percentage points since September and won’t know for months just how weak the economy really is.

“So many of these [economic downturns] are so much clearer when you look back than when you’re in the midst of it,” said Robert Parry, the former president of the San Francisco Fed, who served as a rotating member of the central bank's rate-setting panel.

For the time being, the Fed seems to be erring on the side of cutting rates. Fed Chairman Ben Bernanke signaled a clear shift in a speech this month, saying the Fed stood “ready to take substantive additional action as needed.” Now, a week after cutting rates by three-quarters of a point, the FOMC has to decide whether that move was "substantive" enough — or whether further cuts are needed.

If it turns out the economy has only hit a soft spot, cutting rates further may do more harm than good. Some Fed watchers argue that the current credit hangover is due, in part, to the policy of Bernanke's predecessor, Alan Greenspan, who lowered the benchmark overnight rate to a half-century low of 1 percent and kept it there.  On the other hand, if the economy continues to slide, the Bernanke Fed will face criticism for not moving aggressively enough.

For all its collective wisdom and analytical tools, the Fed has no way of knowing which way the economy will turn in the coming months, said Lee Hoskins, former Cleveland Fed president.

“Economists in general — including Fed economists — are terrible at calling turning points,” he said. “They’re very bad forecasters at that point in time.”

In one worrisome sign, government data showed that the unemployment rate jumped to 5 percent last month from 4.7 percent in November. The Fed won’t get another look at the job picture until Friday, when figures for January will be available. Some economists note that weekly tallies of new filings for unemployment have been falling recently, a sign that the job market may be holding up fairly well.

In the meantime, skyrocketing consumer prices have kept the Fed on alert to a potential outbreak of inflation, which at 4 percent last year was about double the Fed’s target. Cutting rates too sharply could add upward pressure on prices.

“It looks like oil is going to come off this year, and food prices are going to ease up a little bit,  so maybe the Fed will get a break,” said Hoskins. “But they’re still going to end up with an average inflation rate that — from my point of view — is way too high.”

The futures market is betting the Fed will cut at least another quarter-point and maybe a half-point when the meeting concludes Wednesday. 

Still, while the Fed may have rushed to put out the past week’s fire in the global stock market, central bankers don’t like to appear to be setting rates based on what investors are saying or doing.

“Wall Street is greedy,” said Rivlin. “Wall Street will never be satisfied. They’d like interest rates at minus 10.”

It’s also not clear that lowering short-term rates will have much impact on the main source of the economy’s weakness: a housing recession that followed a price bubble.

Despite falling interest rates and some $100 billion in cash pumped into the global banking system by the Fed, credit remains tight as lenders worry about the risk of further losses from bad mortgage debts. Unless the tide can be turned to stop a coming wave of mortgage foreclosures, rising loan defaults this year will dump more empty houses on a market already glutted with too many listings. So far, tumbling mortgage rates have done little to revive the housing market.

“Right now, they won’t — because we’ve built too many houses,” said Rivlin. “We have an overhang of excess supply, and there’s no way that lowering interest rates is going to rev up home construction for quite awhile.”

Sales of new homes fell last year to their lowest levels on record, forcing homebuilders to cut back further and taking a big bite out of spending on home furnishings, appliances and other new home purchases.

Lenders are working to help borrowers who are headed for trouble by refinancing some loans at lowers rates. Congress may help with a move to lift the caps on government-backed loans written by Freddie Mac and Fannie Mae.

But in the long run, there are limits to how far these measures can help those homeowners who got in over their heads — and lenders who simply made bad loans. Hoskins said the Fed can cut rates all it wants, but that won’t solve what he calls an “insolvency” problem.

“A lot of homeowners are going to be insolvent," said Hoskins. "In other words they’re going to lose their homes, and maybe some financial institutions are going to be insolvent. The Fed can pump in a lot of liquidity, but all that does is allow the insolvents to survive a little longer. They’re just delaying the adjustment process.”

Former Fed officials also say that investors and the public may be overestimating just how much the central bank can do to revive a flagging U.S. economy — especially when the weakness is coming from specific regions or sectors like housing.

“The Fed clearly doesn’t have a rifle to deal with problems, it has more like a shotgun,” said Parry. “I think it’s very important to realize that the Fed has limited ammunition to deal with problems in particular part geographic areas or, for that matter, particular industries.”