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Fed's Rate Cut
Could Be Last
For a While
November 1, 2007; Page A1
The Federal Reserve cut interest rates by a quarter point, but with an eye on surging energy prices and other inflationary threats, it strongly discouraged expectations of further cuts.
The decision, following a half-point cut six weeks ago, shows Fed Chairman Ben Bernanke is grappling with risks on two fronts: Plunging home construction and eroding real-estate values could hit the broader economy, while rising oil and commodity prices, combined with a falling dollar, could spoil the Fed's hopes to contain inflation.
Developments yesterday underlined the tension. Though data showed the U.S. economy growing at a faster-than-expected 3.9% annual rate in the third quarter, a purchasing managers' survey showed weak manufacturing in the Midwest in October, the latest in a series of such reports. At the same time, crude-oil futures prices jumped $4.15 to $94.53 a barrel, a nominal record, and gold futures settled at $792.00 an ounce, a 27-year high.
For now, though, investors appear to believe neither of those scenarios will materialize. Stocks initially fell after the announcement dashed expectations of more rate cuts, but then recovered, with the Dow Jones Industrial Average climbing 137.54 points, or 1%, to 13930.01, less than 235 points from its record.
The Fed cut its target for the federal-funds rate, charged on overnight loans between banks, to 4.5% from 4.75%, after cutting it half a point in September. The combined cuts were designed, it said in the accompanying statement, to "help forestall some of the adverse effects on the broader economy" from the summer credit crunch that drove up interest rates paid by many homeowners, corporations and banks.
Growth was solid in the third quarter but likely to slow with the "intensification of the housing correction," the Fed said in its statement. Core inflation, which excludes food and energy, has improved, it said, "but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation."
As a result, the Fed said, "after this [rate cut], the upside risks to inflation roughly balance the downside risks to growth."
In the weeks leading up to the meeting, Fed officials saw their choice as no cut or a quarter-point ease. But their room to maneuver was limited by the fact that markets had become certain there would be a cut and, by last week, perhaps even a larger, half-point cut. Many on Wall Street justified their predictions on the grounds that Fed officials hadn't publicly countered them.
Fed officials don't like to do something just because the markets expect it. But with futures markets assigning a 92% probability yesterday morning to a cut, a failure to deliver would have been the biggest surprise in the 14 years for which comparable data is available, according to Bianco Research LLC, a Chicago financial-research firm. Many predicted that would have led to a stock selloff and increased reluctance to lend.
Alan Blinder, a former Fed vice chairman who teaches at Princeton University, said, "The Fed did not make their views very clear to the markets for about a three-week period in October when they could have. As a result, they wound up being pushed by the market. The Fed has a communications problem when the market's thinking diverges from the Fed's and the Fed doesn't say anything to get back in line."
But Mr. Bernanke has been less inclined than his predecessor Alan Greenspan to try to steer market expectations. And in any case, officials also saw good economic reasons to ease borrowing conditions. Markets remain unsettled and the housing slump could yet spill over more broadly to consumer spending, already weighed down by high energy costs. By some estimates a 4.75% funds rate is high relative to inflation and growth, implying the Fed was likely to ease eventually. Doing so now rather than later bought insurance against worst-case scenarios.
There were hints the decision was a close call. Federal Open Market Committee members voted 9 to 1 to cut, the first time this year a vote hasn't been unanimous. Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, dissented, preferring no cut. Just six of the 12 reserve banks requested the parallel decrease in the discount rate, charged on direct Fed loans to banks, to 5% from 5.25%. That suggests presidents of some of the other banks also would have preferred to stand pat. Just five of the 12 bank presidents have a vote on the FOMC in any given year.
Perhaps mirroring the differing views inside the Fed, outsiders criticized the decision from both sides. Some said the Fed is underestimating the risks posed by the housing bust and credit crunch and will have to ease monetary policy again before long. "The bursting of the housing bubble and strains in parts of the credit markets are profoundly deflationary events, and the Fed's concerns seem out of place," Bank Credit Analyst, a financial research service, said.
But others say the Fed, despite yesterday's promise to monitor inflation pressure, risks stoking it. "The Fed has to walk the walk as well as talk the talk," said John Ryding, an economist at Bear Stearns. "They have to, should the numbers demand it, be willing to reverse the rate cuts. With gold up sharply and the dollar down, the market is still questioning the Fed's commitment to do what it says." The expected inflation rate as implied by trading in inflation-protected Treasury bonds also rose yesterday, though that may reflect short-term trading dynamics.
Despite the rhetoric, the Fed's leadership probably isn't too worried about inflation. Officials believe the tendency of a lower dollar or higher energy prices to become embedded in underlying inflation has declined significantly in recent decades. Their principal source of inflation concern -- the low level of spare capacity in the economy -- has waned as the unemployment rate rises and the economy slows. Wage and benefit costs rose at a subdued rate in the third quarter, the Labor Department said yesterday. The economy is expected to slow sharply in the fourth quarter as high energy prices bite into consumer spending and housing construction tumbles further.
On the other hand, the Fed doesn't see the self-reinforcing dynamics that lead to recession, such as in 2001, when it had to cut rates repeatedly. Rather, it sees the economy as sagging temporarily, as the pool of potential homeowners shrinks to match the tightened terms of credit and the inventory of unsold new homes is worked down, after which it expects growth will return to a normal rate.
Write to Greg Ip at greg.ip@wsj.com
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