Markets expect a Fed rate cut, but it’s no sure bet

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The Federal Reserve has plenty of reasons to cut short-term interest rates and plenty of reasons to leave them alone.

The Federal Open Market Committee meets today to decide what to do with short-term interest rates. The body’s primary monetary policy tool is the federal funds rate, also known as the overnight rate because it’s what member banks charge one another for overnight loans to cover reserves.

The Fed’s target for the overnight rate is 1.75 percent, the lowest it has been for more than 40 years. It has remained at 1.75 percent since December. The prime rate, which banks charge to their biggest and best customers, is pegged to the overnight rate. And some types of consumer debt are based upon the prime rate. The prime rate is 4.75 percent.

Most investors and many economists believe that the Fed will cut the overnight rate by one-quarter or one-half of a percentage point. The prime rate would follow and so would interest rates on some types of consumer debt that are tied to the prime rate — some, but not all, auto loans, credit cards, home equity loans and home equity lines of credit.

Here are reasons for the Fed to cut rates:

  • The economy isn’t growing fast enough. Gross domestic product — the broadest measurement of economic activity — grew at a 3.1 percent annual rate from July through September. That’s roughly how fast the economy can grow over the long term without high inflation, but investors want faster growth during an economic recovery.
  • Inflation is low. The GDP chain deflator, a broad indicator of inflation, stood at 1.1 percent during the third quarter. That’s so low that it gives the Fed room to cut interest rates, an action which generally has the effect of increasing inflation. “I see nothing here to force the Fed’s hand, but with no inflation and no hint of it to come, I don’t see why they won’t take out some insurance. I’m now expecting a 25 basis point cut next week,” says Bill Cheney, chief economist for John Hancock Financial Services.
  • Layoffs continue and businesses aren’t in a hurry to hire. “Though a company is making money, they’re doing it not by increasing production or increasing price but by laying off employees,” says Todd Brown, executive vice president of Patriot National Bank in Melville, N.Y. As layoffs continue, consumers won’t spend as much, triggering further layoffs. A rate cut is seen as a way to slow this cycle (although increased government spending might be a more effective way).
  • Shoppers are scared. The Conference Board’s consumer confidence index has dropped to 79.4, a nine-year low. That alarms retailers who want consumers to wear their shopping shoes over the next two months. “I think the consumer confidence lows that we hit this week may be, contrarian that I am, a good sign that everyone gets it — that this has been such a devastating time for many people in this country,” says Ellen Bitton, chief executive of Park Avenue Mortgage Group in New York.
  • Numbers from the trading floor hint that investors are confident of a rate cut. This week, the yield on two-year Treasury notes dropped below 1.75 percent — in other words, below the overnight rate. That indicates that traders believe the Fed will cut short-term rates. Also, the Chicago Board of Trade had priced in an 84 percent possibility of a Fed rate cut when the trading day ended Wednesday.

Here are reasons for the Fed to keep rates steady:

  • The economy is growing. Sure, it’s not expanding as rapidly as some would like, but the pace of growth is increasing. The economy grew at a 1.3 percent annual rate in the second quarter, then at a 3.1 percent annual rate in the third quarter.
  • “We’re moving forward and eventually we’ll get where we want to be, but it’s maddeningly slow getting there,” Cheney says. Although he still believes the Fed will cut rates to be on the safe side, he emphasizes that gross domestic product “was still reasonably strong and, most important, it represents real economic growth.”
  • Lynn Reaser, chief economist for Banc of America Capital Management, makes much the same point. Speaking Thursday, a day before key manufacturing and employment statistics are released, she says: “If the numbers show reasonable stability, it would be my view that the Federal Reserve should not overreact to negative numbers and the economy will get on track over the next several months.”
  • Today’s economic problems are transitory. Richard DeKaser, chief economist for National City Corp., says the current economic woes result from worries about pending war in Iraq and fallout from the recent dockworkers’ lockout on the West Coast. “These are each events that should be fleeting in nature,” DeKaser says. “They’re not the kind of long-term problems that can be dealt with using monetary policy.”
  • Influential members of the Fed have hinted over the last few weeks that they lean toward keeping rates steady. “Every time they would discuss the economy, they would describe monetary policy as ‘accommodative,'” DeKaser says. “Accommodative” is Fedspeak for saying that interest rates are low and designed to stimulate the economy.

Michael Moskow, president of the Federal Reserve Bank of Chicago, said in a speech Oct. 29 that “the economy is currently experiencing a soft spot,” but that output will increase in 2003. Those don’t sound like the words of a man who would be surprised by 3.1 percent GDP growth in the third quarter or of a man who is eager to cut interest rates. Moskow uttered “accommodative” four times in his speech.

Speaking Thursday, DeKaser says he believes the Fed will stand pat, although “it’s an opinion I hold with weak conviction at this point.” Much depends on payroll statistics to be released Friday. If the economy shed a few jobs in October, the Fed will be inclined to keep rates alone, he believes. But if net job losses are in the 60,000-to-80,000 range, the Fed might feel compelled to cut rates.

— Posted: Nov. 1, 2002