How Low Will the Fed Go?

Chairman Bernanke is hearing it from all sides, but the rate doves appear to have the upper hand

As Federal Reserve Chairman Ben S. Bernanke and company consider how far to cut interest rates, they are getting harangued from all sides. Slash rates drastically to keep the financial system from freezing up, say some backseat drivers. No, say others, there's no sign yet the economy as a whole is in enough trouble to warrant deeper cuts.

The discussion over what to do next is tied to a different debate about whether the Fed made a mistake and cut rates too far in 2003 and 2004. Back then, under former Chairman Alan Greenspan, the Fed dropped the fed funds rate—the main short-term interest rate it controls—as low as 1%. In doing so, it staved off the economic collapse many economists feared after the tech bust and stock market decline. However, critics charge that the amount of money the Fed pumped out was so large it led to harmful speculation in the housing market. Morgan Stanley (MS) economist Stephen Roach says the Fed became a "serial bubble blower."

Investors seem to expect that big cuts will win the day. As of Feb. 13, the fed funds futures market was betting the funds rate to be cut from 3% to 2.5% at the next Fed rate-setting meeting on Mar. 18, according to a Bloomberg Financial Markets calculation. Further out, the futures market anticipates the fed funds rate will go to 2% by June.

Bad News Keeps Coming

Robert DiClemente, Citigroup's (C) head of U.S. economic and market analysis, is predicting a bottom of 2.25% but concedes it could well go lower. Says DiClemente: "There's this very nasty chemistry between economic weakness and financial instability and back. It just keeps feeding on each other until the Fed breaks the circle." One of Wall Street's biggest bears, David Rosenberg, North American economist for Merrill Lynch (MER), thinks the funds rate will hit 1%.

Certainly the bad financial news keeps coming. On Feb. 11, American International Group (AIG) announced it will be forced to write down the value of its mortgage-related financial instruments by nearly $5 billion. On Feb. 13 the biggest U.S. mortgage insurer, MGIC Investment, posted a record quarterly loss of $1.47 billion because of a huge rise in delinquencies.

There's no sign of a pickup in the credit markets. Banks are burdened with leveraged-buyout loans they can't sell. They're sharply tightening standards for loans on commercial real estate, which until now had held up much better than residential real estate. And the sharp decline in home prices, which triggered the credit crunch and shows no sign of ending, looms large.

Cuts Not an Easy Call

Bernanke and others at the Fed are attuned to the risks. A leading scholar on the Great Depression, Bernanke has made clear in speeches his determination not to let the credit crunch drag down the overall economy. One influential Fed governor, Frederic Mishkin, argued in a Jan. 11 speech that monetary policymakers "may need to react aggressively" in times of financial turmoil and take preemptive action even before the macroeconomic fallout is apparent.

But that doesn't mean big rate cuts are an easy call. Bernanke faced dissent in each of the last two rate-cutting votes, by St. Louis Fed President William Poole on Jan. 22 and Dallas Fed President Richard Fisher on Jan. 30. Laurence Meyer, a former Fed governor who is vice-chairman of St. Louis-based Macroeconomic Advisers, predicts the Fed will cut only another quarter- or half-point and is likely to be raising rates again by yearend.

Hawks say there's no need to run the risk of reinflating bubbles because the economy is fundamentally healthy and inflation is a greater risk than recession. Including food and energy prices, the consumer price index rose 4.1% in 2007, notes Ken Mayland, president of ClearView Economics in Pepper Pike, Ohio. And on Feb. 13 the Census Bureau reported a 0.3% gain in retail sales in January, bolstering hopes that consumers will keep the U.S. out of recession.

Repeating Recent History?

Tom Sowanick, chief investment officer of Clearbrook Financial, a Princeton (N.J.) asset manager, says the economy is getting all the help it needs from the recent rate cuts, the fiscal stimulus package signed Feb. 13 by President Bush, and corporate actions such as Warren Buffett's offer on Feb. 12 to reinsure $800 billion of municipal bonds for strapped bond insurers. Big rate cuts would be required, he says, only if Buffett's offer isn't accepted by the major insurers, leading to rating downgrades, or if it turns out financial institutions still haven't come clean about the extent of their recent losses.

The rate-cutting skeptics also worry the Fed will overcorrect and drive the economy into a new round of speculation. They argue that in 2003 and 2004 the Fed erred on the side of stimulus when it wasn't needed and set the stage for the housing bubble. "Everyone's wondering whether that was too far," says Mayland. "I'd be real surprised if we see 1% again."

The more dovish, alternate viewpoint is that the ultralow interest rates of 2003-04 were not the real problem. Rather, the policy mistake was raising rates so rapidly afterward. In the space of only two years, the Fed jacked up interest rates by more than four percentage points, faster than the markets could adjust.

In retrospect, it's clear the higher rates had an unexpectedly negative impact on the housing market. Starting with the third quarter of 2005, private investment in new residential structures began decelerating sharply. Nevertheless, the Fed didn't stop hiking rates until June, 2006. Since it takes 12 to 18 months for changes in interest rates to have their full effect, housing was getting hit hard long after it had started to slow.

Raising Rates, Lowering Standards

Part of the problem was that the official figures at the time were misleading, showing a stronger housing market than actually existed. For example, when the Fed raised rates in January, 2006—at Greenspan's last meeting as Fed chairman—the available numbers seemed to indicate that new-home construction was rising at a very strong 11% annual rate in the fourth quarter of 2005. In fact, the rate was half that, once all the revisions were in.

The rate hikes also had a perverse effect: Lenders were determined not to lose customers when rates rose, so they lowered standards. The default rate on mortgages loans made in 2006 and 2007 was much worse than that of loans made during the lower-rate period.

Fed policymakers reject the notion that they tightened rates too much from 2004 to 2006. They were worried about inflation accelerating, and they didn't see a 5.25% fed funds rate as being particularly high in historical context. On the other hand, they dismiss the contention of skeptics such as Roach that the Federal Reserve eased too much in 2003 and 2004. That's important because it means Bernanke is not likely to shy away from cutting rates if the Fed believes the economy demands it.

How low will rates go? As low as they need to.

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