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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 SchererStaff writer of The Christian Science Monitor / January 29, 2008

Juggling act: A week ago, economists expected that the Federal Reserve would go with a larger rate cut, but then the House revealed plans for a bipartisan economic stimulus package. Here, Treasury Secretary Henry Paulson (c.), with House Minority Leader John Boehner (l.), and House Speaker Nancy Pelosi, gestures while discussing the stimulus package during a news conference on Capitol Hill.

Dennis Cook/AP

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

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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.

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