Fed's tough call: how far to cut interest rates

A week ago, analysts expected a 0.5 percentage point trim. Now they're not so sure.

By Ron Scherer | Staff writer of The Christian Science Monitor

from the January 29, 2008 edition

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New York - A newly aggressive Federal Reserve is poised to take its next push to jump-start the US economy.

But how hard to push comes at a sensitive moment for the economy. Cut interest rates too little and already jumpy markets could plunge, worsening an economic slump. Cut rates too much and, because of the lag time involved, the central bank risks overheating an economy later in the year.

That is why only a week after the central bank cut interest rates by three-quarters of a percentage point, Fed watchers are divided over how much it will knock down rates: Some say only one-quarter of a percentage point; others expect the Fed to go with half a percentage point.

The size of the rate cut can mean a big difference in the long run, affecting everything from what businesses pay for financing expansion to the interest Americans pay on their credit cards.

A week ago, many economists had expected the Fed to go with the larger rate cut. But since then, the US House has proposed a $150 billion stimulus package, which might well grow once it passes the Senate. Financial markets remain unsettled but are not in free fall as they were last week. And economists believe any cut now can be followed up with more cuts in the future if the economic indicators continue to weaken.

"I think they will cut rates, but will only go with a quarter of a percent," says Lyle Gramley, a former Fed governor and a consulting economist at Stanford Group in Washington. "They can leave the door open for more."

The challenge is that Fed cuts take at least nine months to work their way through the economy. So if central bankers overreact now and the economy rebounds in the fall, they could worsen inflation. However, if the Fed does not cut rates now, some economists argue it could deepen the slowdown.

"If the Fed does not act, the markets will react much more harshly than they have," says Keith Hembre, chief economist at First American Funds in Minneapolis. "It would suggest the economy would be in a deeper downturn if they did nothing."

However, Mr. Hembre says any bounce to the economy will also depend on how quickly the economic-stimulus package gets approved by Congress. "By the time they distribute the checks, it might be May. So by the third quarter we could see a boost to personal disposable income," says Hembre.

The Fed's decision comes at a time when fresh indicators are giving a clearer picture of the direction of the economy. On Monday, the Commerce Department reported that new home sales in December fell 4.7 percent. For all of 2007, new home sales were off a record 26.4 percent. Prices rose only 0.2 percent, the worst showing in 16 years.

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Conundrum: Federal Reserve Board Chairman Ben Bernanke is shown during a Jan. 14 meeting on Capitol Hill. A newly aggressive Federal Reserve is ready to take its next push to jump-start the US economy, but the Fed must figure out how hard to push. Cut interest rates too little and already jumpy markets could plunge. Cut rates too much and the central bank risks overheating the economy later this year. Dennis Cook/AP