Concerned that turmoil in the credit markets might spark a broader economic slide, the Federal Reserve is now signaling that it may cut interest rates – perhaps next month.
An interest-rate cut would be the latest weapon employed by the central bank to try to bolster the short-term debt markets, which have been frozen by investor fears about the quality of loans.
Some analysts worry that the economy, though strong now, could skid to a halt by year's end if investor confidence isn't restored. The Fed itself now acknowledges that credit-market problems could spill over to the broader economy. The risks to growth "have increased appreciably," it said in a statement Friday.
"The odds of a recession are now 50-50," says Lyle Gramley, a former Fed governor. "Conditions have become extremely unstable and outright chaotic in the mortgage market."
For more than a week, the Fed, as well as other central banks around the world, provided overnight emergency funds to try to ease the pressure on the world's commercial banks. Despite those efforts, the credit markets are still jittery. On Friday, as part of its efforts to change the psychology in the markets, the Fed also cut the discount rate by half a percentage point. The discount rate, one of the Fed's more obscure monetary levers, is the rate at which commercial banks can borrow money from the Fed itself.
"The Fed's lowering of the discount rate helped to solve some of the concerns," says Michael Carey, an economist at Calyon, a French investment bank, in New York.
On Friday, after the Fed's announcement, the stock market recouped some of its recent losses with the Dow Jones Industrial Average gaining 233.30 points to close at 13079.08, up 1.8 percent.
Economists also believe the Fed will act to lower the short-term interest rates known as the Fed Funds rate when it meets on Sept. 18. The Fed Funds rate, which has more direct bearing on short-term consumer rates, is the interest rate which banks lend their balances at the Fed to other banks. The current rate is 5.25 percent.
"I think there is a 90 percent chance they will ease on Sept. 18," says Mr. Gramley, now a consulting economist at Stanford Policy Research in Washington.
Some Wall Street economists expect the Fed to drop rates in October and December as well.
On Aug. 7, the Federal Reserve held interest rates steady and said the downside risk to growth had only "increased somewhat." Instead, it said it was more concerned about the risk of inflation.
The Fed has overestimated the inflation threat, says economist Lincoln Anderson of Boston-based LPL Financial Services. The core inflation rate, the rate not counting energy or food, is now down to 1.9 percent, he points out. This rate is within the Fed's comfort zone. "Why tilt against an inflation surge when that is not happening?" he asks.
If the Fed does cut rates, it will come at a time when the economy is still showing that it has some spunk left in it. Last week, the government reported that July industrial production rose at an annual rate of 0.3 percent after rising 0.5 percent in June. Exports are rising and business is beginning to spend more on inventory replenishment.
"The economic data is not all that bad," says Jay Bryson, a senior economist at Wachovia in Charlotte, N.C. "The economy is growing at about 2.5 percent to a 3 percent rate."
But, that economic activity took place before the current credit crunch.
Mr. Carey says his economic modeling shows the restrictive credit conditions could take as much as 0.5 percent off economic growth next year. This would put economic growth below 2.5 percent next year, below trend. "There are a lot of downside risks," he says.
One of those risks, says Gramley, is that the housing market slows even further as it becomes increasingly difficult to get a mortgage because banks can't resell them in the secondary market.
"We need to inject some liquidity into the secondary market [for mortgages], which is completely frozen," he says. "Unless the administration wakes up, the recession will begin in November or December of this year," he warns. "And it may not end until next September, which is right around the corner from Nov. 6," Election Day.
Gramley believes the way to inject liquidity is for the Bush administration to temporarily lift the ceiling on the holdings of Fannie Mae and Freddie Mac, the quasi-government buyers of mortgages. Both agencies have reached the maximum amount they can hold in their own portfolios. Only last week, President Bush said he wanted the two entities to undergo reforms before he would allow them to increase their portfolios.
On Friday at a press conference, Sen. Christopher Dodd (D) of Connecticut urged Mr. Bush to act. He estimates the move could add about $80 billion in liquidity to the mortgage market.
"There is enough regulatory authority for the caps to go up 5 percent without violating existing law," said Senator Dodd, chairman of the Senate Banking, Housing, and Urban Affairs Committee. "The idea [that] we do reforms first is not a legitimate answer."