With wreckage piling up, Fed eyes another rate cut

[October 27, 2008]  WASHINGTON (AP) -- As the economic wreckage piles dangerously higher, the Federal Reserve is prepared to ratchet down interest rates -- perhaps to their lowest point in more than four years -- with the hope of relieving some of the pain felt by many Americans.

The convergence of a housing collapse and a lockup in lending has created the worst financial crisis in more than a half-century. Alan Greenspan, who ran the Fed for 18 1/2 years, called it a "once-in-a century credit tsunami," and conceded that he made mistakes that may have aggravated the economy's slump.

With a recession seen as inevitable, if not already under way, any Fed rate cut would be aimed at cushioning the fallout.

Vanishing jobs and shrinking paychecks have forced consumers to cut back sharply. Millions of ordinary Americans have watched their 401(k)s and other nest eggs shrink and the value of their homes drop, making them feel in even worse financial shape. In turn, businesses have cut back on hiring and other investments as customers hunker down and credit problems make it harder and more costly to get financing.

"These are sobering times," said Paul Kasriel, chief economist at Northern Trust Co.

All the problems have been feeding on each other. So far, Fed Chairman Ben Bernanke and his colleagues haven't been able to break the vicious cycle, despite hefty rate reductions and a flurry of unprecedented steps aimed at getting credit flowing more freely again.

Bernanke says he'll use all tools to battle the crisis.

To that end, Fed policymakers are widely expected to lower the central bank's key interest rate at the conclusion of a two-day meeting Wednesday -- their last session before the November elections.

Investors and some economists predict the central bank will drop the rate by half a percentage point to 1 percent. If that happens, it would mark the lowest rate since the summer of 2004. Others, however, think the rate will be cut by a smaller, quarter-point to 1.25 percent.

In turn, rates on home equity, certain credit cards and other floating-rate loans tied to commercial banks' prime rate should drop by a corresponding amount. A half point reduction would leave the prime rate at 4 percent; a quarter-point cut would drop the rate to 4.25 percent. Either way, the prime rate would be the lowest in more than four years.

The Fed hopes that lower rates will spur people and businesses to spend again, helping to brace the wobbly economy.

"I think it would be a good faith psychological move," said Richard Yamarone, economist at Argus Research. However, Yamarone and others doubt that another rate reduction will entice people -- many buried under piles of debt -- to ramp up spending. But it might help a little, they said.

Consumer spending -- which accounts for the single-biggest chunk of overall economic activity -- probably fell in the July-to-September quarter. That would mark the first quarterly drop since late 1991, when the country was coming out of a recession, economists said.

Given that, many predict the national economy contracted in the third quarter. The government releases the report on gross domestic product on Thursday.

GDP measures the value of all goods and services produced within the United States and is the broadest barometer of the country's economic health. Many also believe the economy will continue to contract through the rest of this year and into next year. All that would more than meet a classic definition of recession -- two straight quarters of shrinking GDP.

Bernanke has repeatedly warned that the country's economic weakness could last for some time -- even if the government's unprecedented $700 billion financial bailout package and other steps do succeed in getting financial and credit markets to operate more normally.

Many expect the unemployment rate -- now at 6.1 percent -- to hit 7.5 percent or higher by next year. Employers have cut jobs each month so far this year. A staggering 760,000 jobs have disappeared.

Whether Democrat Barack Obama or Republican John McCain, the next president will inherit a deeply troubled economy and a record-high budget deficit that could cramp his domestic agenda.

Kasriel thinks another rate reduction could help squeezed banks.

Lowering rates would increase the difference between the rate banks charge each other to borrow overnight and the rates they are paid on investments in super-safe Treasury securities, a popular investment these days given the chaos in credit markets and on Wall Street, he said. "That will improve profits and will enable banks to restore their capital," Kasriel said.

To unclog credit, the Treasury Department recently announced a historic step, saying it would inject up to $250 billion into banks in return for partial ownership. The hope is that banks will use the capital infusions to rebuild their reserves and boost lending to customers. The money also can be used by a bank to buy another bank, strengthening both to better weather the financial storms.

Earlier this month, the Fed and other central banks joined together to slash rates, the first coordinated move of that kind in the Fed's history. That dropped the Fed's key rate down to 1.50 percent and marked an about face in policy. The Fed in June had halted an aggressive rate-cutting campaign that had started in September, aimed at shoring up the economy.

The Fed had moved to the sidelines out of fear that its rate cuts would worsen inflation. Since then the inflation threat has lessened. The threat of a global recession has dampened once surging prices for energy, food and other commodities.

Now a few economists are starting to worry about deflation -- a widespread and dangerous bout of falling prices -- if the U.S. and world economy get stuck in a long and painful recession.

The remote -- but powerful concern about deflation -- was among the reasons why the Greenspan Fed held rates at very low levels for so long in the aftermath of the last recession, in 2001. By the summer of 2003, Greenspan had ratcheted down the Fed's rate to 1 percent, which was the lowest since 1958. The Fed held rates at those historically low levels for one year before beginning to bump them up to fight inflation.

Critics contend that those low rates fed the housing bubble and lax lending standards that eventually would burst and imperil the economy. The meltdown drove up foreclosures and forced financial companies to wrack up huge losses on soured mortgage investments, laying low storied Wall Street firms and causing banks to fail.

[Associated Press; By JEANNINE AVERSA]

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