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.

from the January 29, 2008 edition

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On Tuesday, the Fed will also get a look at December durable-goods orders, considered to be an indicator of future economic activity. The overall number is expected to grow because of strong year-end sales of aircraft. Even without aircraft it's expected to grow by over 1 percent. "However, if that number is down, then the Fed will drop rates by half a percentage point," says Mr. Gramley.

Before the Fed makes its announcement, it will also get a chance to see the Commerce Department's preliminary estimate of the growth rate of the gross domestic product in the fourth quarter of 2007. Economists expect it will show a growth rate of 1 to 1.5 percent. "If it comes in negative, it would make them go to a half a point reduction. But if it comes in stronger, then maybe they will do nothing," says David Wyss, chief economist for Standard & Poor's in New York.

On Friday, after the Fed's decision, the Department of Labor will report the January employment numbers. Early expectations are for another weak report with the unemployment rate rising slightly and a modest number of new jobs added to the economy.

However, the Labor Department will also announce revisions of previous months, based on the creation or demise of actual businesses. Early expectations are for a decline of 300,000 jobs.

But economists have been perplexed by another government report: new unemployment claims. For the last several weeks, Americans have been filing an average of about 300,000 such claims a week.

Typically during a recession, they file closer to 350,000 new claims, economists say.

"It could be the labor market is stronger than we think, or it could be because seasonal hiring in December was weaker so not as many people are getting laid off," says Wyss.

But the Fed will also have to consider financial-market expectations. The bond market has already priced in a half-a-point reduction in rates. "If the Fed is not close to a half-point reduction, the market will be disappointed," says Ann Owen, an economics professor at Hamilton College in Clinton, N.Y. "I think they knew that when they cut rates by three-quarters of a percentage point so close to the meeting."

Ms. Owen, a former economist at the Federal Reserve, thinks the Fed realizes its job is now more difficult because of the problems in the financial sector. Banks have been reporting large losses and have tightened up their lending standards. "It's a risky move if you cut rates and it doesn't work," she says.

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