The Fed's Trick or Treat

In light of growing recession fears, many expect a rate cut on Oct. 31, but will oil prices and the weak dollar spook Bernanke & Co.?

There comes a point during every drunken Halloween bash when the host is forced to remove the punch bowl because the witches, warlocks, George Bushes, Osama bin Ladens, and slutty nurses are getting just a little too rowdy. This year, the most important Halloween party is being held in Washington at the headquarters of the Federal Reserve.

Precisely on Oct. 31, the Fed's somewhat dour rate-setting committee will announce whether or not it is about to snatch away the monetary punch bowl from the U.S. economy and the financial markets. If the Fed cuts interest rates, it means punch is still being served and the party can keep rocking. If it refuses to cut rates, keeping the benchmark federal funds rate at 4.75%, the party will come to an abrupt halt and the stock market most likely will develop a severe headache.

So, cut or no cut? The betting is that Fed Chairman Ben Bernanke and his fellow members of the Federal Open Market Committee will go ahead and make a Halloween rate cut. According to Bloomberg Financial Markets' Federal Funds Implied Probability calculator, which is based on prices of options, markets as of Oct. 25 were setting a 69% probability on a quarter-point cut in the funds rate, to 4.5%. They were putting a 22.5% chance on a half-point cut, to 4.25%. They were putting only an 8.5% chance that the Fed would get all chaperone-like and refuse to cut rates.

Haunted Housing

More than anything, what's behind the likely cut is the continued decline of the housing market, which threatens to drag down the entire economy. Merrill Lynch (MER) Economist David Rosenberg, one of the more bearish figures on Wall Street, wrote on Oct. 26: "We think a miracle is needed to avoid recession." This past week, the National Association of Realtors announced a 10% decline in sales of existing homes from August to September.

A day later the Census Bureau announced a nearly 5% monthly increase in sales of new homes, but analysts were quick to point out that September sales were actually 3% lower than August as originally reported. Sales for June, July, and August were all revised lower. And the September number doesn't factor in order cancellations, which are massive. Merrill's Rosenberg pointed out that D.R. Horton (DHI) announced recently that roughly half its orders were canceled between July and September.

Worries and Euros

But the decision to cut rates isn't as easy as dropping a candy bar into some trick-or-treater's bag. First, not all economists are as worried as Rosenberg is about recession. Wachovia (WB) economists wrote Oct. 26 that, although they expect a rate cut in October and another in December, it's not a crisis situation: "Strong gains in consumer spending and a significant rise in exports more than offset" a big drop in residential construction, they wrote.

At the same time, the Fed remains worried that making borrowing money too easy will stir inflation. That concern undoubtedly intensified this week when inflationary pressures strengthened from two sources. Crude oil for December delivery rose nearly $5 a barrel during the week to a record of $91.18 on the New York Mercantile Exchange. The threat of U.S. conflict with Iran, which is a major oil producer and a significant military power, was largely responsible for lifting oil far above its natural level based on current supply and demand. High oil prices will probably lift gasoline at the pump back to well above $3 per gallon.

Meanwhile, the dollar fell to a new low against the euro. It took nearly $1.44 to buy a euro on Oct. 26. According to a Bloomberg calculation, the dollar has dropped against all of the 16 most actively traded currencies this year. A cheaper dollar raises the cost of imports, fueling inflation.

The bottom line: The Fed rate-setters are likely to cut rates on Halloween and very possibly again at their next rate-setting meeting on Dec. 11. But they won't like doing it. Ben Bernanke & Co. are grumpy party hosts who ladle out the punch with a grimace.

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