Fed expected to cut interest rates Tuesday

For the first time since June 2003, it looks as if the Federal Reserve will be lowering interest rates.

If the nation's central bank does so Tuesday, it will signal that it now views a slowdown as a greater threat than the risk of rising prices. How much it lowers rates will provide a clue as to how deeply the central bankers feel the economy has been damaged by the turmoil in the credit markets.

Many economists expect a Fed rate reduction would just be the start of a program of lower rates – with more to come in October and possibly again in December or January. "It's like potato chips: You can't just do one of them," says David Wyss, chief economist at Standard & Poor's in New York.

A Fed move on short-term rates can ripple through auto loans and short-term corporate borrowing fairly quickly. Lower interest rates could also bolster consumers, since credit cards are often pegged to short-term rates. But mortgage rates, which have been falling, are more widely linked to long-term interest rates.

The full effect of an interest shift can take 18 months to work its way through the economy.

Many economists expect the Fed to reduce the federal funds rate, the rate that banks loan one another their excess reserves at the Fed, by a quarter of a percentage point. "It's already priced into the market, and if they don't do it, there will be a negative reaction," says Ann Owen, a professor of economics at Hamilton College in Clinton, N.Y., and a former economist at the Fed.

Yet some economists think the Fed will be more aggressive, dropping interest rates by a half of a point. "The Fed can afford to take a substantial insurance policy with inflation pressures much reduced," argues Richard DeKaser, chief economist at National City Corp. in Cleveland.

Any Fed action will follow the August payroll (employment) report, which showed a net loss of 4,000 jobs. In past statements from the Fed, the central bankers fretted over tight labor conditions that could lead to wage inflation.

Bill Knapp, chief investment strategist at MainStay Investments in New York, argues the drop in jobs is actually worse. The household survey, issued at the same time as the payroll report, indicates a loss of 17,000 jobs per month for all 2007 and 300,000 jobs last month alone, he says. "Even if the Fed does not look at those numbers, it seems their comments about a tight labor market now seem mitigated if not eradicated by the payroll report," he says.

The drop in jobs mirrors a slower economy, Mr. Knapp says. By the last quarter this year, he says, the economy will be running at under a 2 percent annual growth rate. "I'm not predicting a recession, but I think the odds are now up to 40 to 50 percent," he says.

Other economists, however, question why the Fed needs to act at all. One of them is Bob MacIntosh, chief economist at Eaton Vance, a mutual fund group in Boston. "I see enough going on in the economy, including some forward-looking data on exports that are doing well. So I don't think they need to cut rates yet," he says. "They should let things play out for a couple of more meetings."

A rate reduction by the Fed will also help to weaken the dollar, which has been sinking to historic lows compared with the euro. "A lower-valued dollar potentially creates problems with respect to the inflation numbers," says Mr. DeKaser.

If the Fed does reduce rates, it will be their first interest-rate action since problems in the subprime mortgage arena spilled over to the credit markets. (Subprime mortgages are made to individuals with less-than-stellar credit records.)

As that crisis began to unfold, the Fed provided billions of dollars of short-term liquidity to financial markets. It reduced the discount rate, the rate banks can borrow directly from the Fed, by half of a percentage point. Some economists expect it will also reduce that rate Tuesday.

Last Friday, the ripple effect of the liquidity crisis continued to spread. In Britain, Northern Rock, a mortgage and banking company, announced it had gone to the Bank of England for short-term funding. Analysts said it was an issue of market ill-liquidity since the company has very low loss rates on its mortgages.

Ironically, Northern Rock's search for funding came after some stability returned to the asset-backed commercial paper (ABCP) market, which provides short-term funding for loans backed by assets. The Federal Reserve reported last week that, two weeks ago, dealer-placed ABCP fell $22.2 billion. This was a major improvement over the prior three weeks, when it fell $160 billion.

"The smaller declines suggest a greater share of CP programs are successfully being placed," wrote Citigroup economist Steven Wieting, in a memo to clients. However, he cautioned, crucial tests lie ahead, including Tuesday's meeting.