Can a Fed rate cut make credit flow?

An interest-rate move Wednesday could make some loans cheaper than at any time since 2003.

By , Staff writer of The Christian Science Monitor

For the ninth time in just over a year, the Federal Reserve on Wednesday is expected to cut interest rates, quite possibly its last reduction in this downturn.

The Fed's move would probably take rates to the lowest levels since 2003, when the economy was growing at a snail's pace, and could mean a full percentage point decline this month alone, a rare sharp drop and an indication of how quickly the central bank sees the need to respond to the sinking economy.

The rate reduction co-incides with a Fed rule change that allows it to pay interest on banks' excess reserves – a change that experts say gives Fed Chairman Ben Bernanke the ability to provide almost unlimited liquidity to the US banking system. This October one-two combination will be a powerful lever for the economy, economists say, perhaps enough to finally begin to relieve some of the pressures on credit markets.

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"The Fed is pushing on the accelerator as hard as it can," says Mark Zandi, chief economist at Moody's Economy.com. "By paying interest rates on reserves, the Fed is able to provide so much cash to financial institutions that there will be no reason for them not to lend to one another and, by extension, to business and households."

If the Fed is successful, the change will be welcomed by struggling corporations, some of which are now paying more than 18 percent to borrow money. Even some investment-grade companies are paying as much as 9 percent.

"Anything with risk attached is [stuck with] high rates, so lowering rates would be helpful," says Mr. Zandi.

The Fed's move on Wednesday is expected to lower the federal funds rate – the rate at which banks lend their excess reserves through the central bank to other financial institutions – to 1 percent. Economists anticipate that other major central banks will also lower rates in a coordinated rate cut much like the half-a-percentage point drop in early October.

If the Fed were to lower rates further – below 1 percent – it would mark the lowest level since the mid-1950s.

"Once you get to 1 percent, you are basically out of bullets" to stop an economic slump with interest-rate cuts, says Joel Naroff of Naroff Economics in Holland, Pa. "They really don't want to make that move."

The Fed may also be wary of providing the economy with so much firepower that it touches off another bubble.

"There is a lot of mindfulness at the Fed [that] there can be too much of a good thing," says Richard DeKaser, chief economist at National City Corp., a Cleveland-based bank. "There is a point of view that one of the factors that contributed to the housing-market bubble was the excessively low interest rates early in the decade, and the Fed is worried about repeating that mistake."

However, at the moment, the biggest worry is about the economy. Layoffs are now starting to occur at a much faster pace. Consumers are pulling back – way back.

On Monday, the Commerce Department reported new home sales actually rose 2.7 percent in September. Housing analysts were cheered to see the inventory of new homes fall from 11.4 months to 10.4 months of supply. However, the improvement came at a cost – the median price declined by 9.1 percent from a year ago. Housing analysts pointed out that one-month numbers can be volatile since they are taken from a small sample.

"Going forward, sales will continue to drop because of falling house prices for existing homes, tighter credit, and a deteriorating economy," wrote Patrick Newport, US economist for IHS Global Insight in Lexington, Mass.

This week will start to provide economists with a better idea of how much the economy is falling.

On Wednesday, the government will report the durable goods orders for September. In August, they had their sharpest drop in two years. On Thursday, the government will release its first look at third-quarter gross domestic product. Economists anticipate it will show the economy declined by about 0.5 percent.

"This recession could have the dimension of 1981 to 1982. That was the deepest we have had in recent times," says Lyle Gramley, a senior economic adviser at Stanford Washington Research Group and a former governor of the Federal Reserve.

Mr. Gramley expects layoffs, which began in earnest in September, to start cascading. He anticipates that the unemployment rate, currently at 6.1 percent, may peak at somewhere between 8 and 9 percent, which would be the highest rate since 1982.

"People have a sense of foreboding; there is a sense everywhere that the economy is in big trouble," says Gramley.

Fed watchers expect the Fed, in its statement on Wednesday, to talk about the risk to growth in the economy, playing down inflation issues. In his recent testimony, Mr. Bernanke has talked about how commodity prices have fallen, which should relieve inflation pressures, which have been running at about a 5 percent annual rate.

On Monday, commodity prices continued to fall, with the price of oil dropping below $63 a barrel. Over the past two weeks, the average price of gasoline has fallen 50 cents a gallon nationally, according to GasPriceWatch.com. This should help consumers.

However, it will probably not be enough to help US retailers. "This will be a miserable Christmas season," predicts Gramley.

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