Will the Fed save the day?
Bernanke & Co. did not signal an imminent rate cut at the Fed's last meeting, but some think the Fed will take emergency action as the credit crunch gets worse.
NEW YORK (CNNMoney.com) -- Is it time for Fed chair Ben Bernanke to take a page from his predecessor's book and lower interest rates to soothe a jittery market?
Or will the news that the Fed injected $38 billion into the U.S. banking system Friday be enough to save Wall Street?
Former Fed Chairman Alan Greenspan helped allay Wall Street's worries several times during his tenure with emergency rate cuts in between scheduled meetings of the Fed's policy making committee.
Under Greenspan, the Fed cut rates in September 2001 following the 9/11 terrorist attacks and also in January of that year due to signs of a weakening economy. The Fed also cut rates in October 1998 in response to the Asian financial crisis that led to the collapse of a prominent hedge fund in the U.S.
Now investors are dealing with another financial crisis. Wall Street is in a full-blown panic about credit problems wreaking havoc on banks and potentially the overall economy.
Still, it was only a few days ago that the Federal Reserve decided to leave rates unchanged and hinted that it was not too worried about tightening credit standards. Wall Street interpreted this as a sign that an interest rate cut was unlikely in the next few months.
But in the past few days, stocks have plunged as more financial institutions have reported problems related to bad loans, particularly subprime mortgages to borrowers with poor credit histories.
As such, investors are now pricing in the possibility of an emergency quarter-of-a-percentage point interest rate cut sometime this month, according to federal funds futures listed on the Chicago Board of Trade.
The federal funds rate, a key short-term rate that determines rates for credit card loans, home equity loans and other types of consumer and corporate loans, currently stands at 5.25 percent.
So will the Fed step in to try and save the markets?
"The housing and mortgage problems are a major issue facing the economy, but I think it's doubtful at this point the Fed feels so stressed about it that it would make a move between meetings," said Keith Hembre, chief economist with First American Funds in Minneapolis.
Hembre quickly added though that he expects the Fed to cut rates at its next meeting in September. He said that the Fed, which is still worried a bit about inflation, probably would want to see how the August employment report shapes up before making up its mind about a rate cut.
The unemployment rate for July inched up to 4.6 percent. If the unemployment rate ticks up in August to 4.7 percent, Hembre said the Fed would probably feel comfortable cutting rates since that would be a firm sign that the economy is weakening and would be in need of a boost.
But the Fed may not have the luxury of waiting that long. David Kelly, senior economic adviser with Putnam Investments, said that even though the Fed probably would rather hold off on a rate cut, market turmoil may force its hand as it did for the Maestro in 1998 and 2001.
"If the credit situation gets worse, the Fed could come back and cut rates as soon as next week. The Fed will look back at other crises like 9/11 and the Asia financial crisis for guidance," Kelly said. "I hope the Fed doesn't have to react, but if it does it will be because of the markets. In the end, hysteria is dangerous and it can have economic consequences."
Still, some argue that a rate cut could be counter-productive since it could weaken an already moribund dollar, which in turn, could make U.S. Treasurys less attractive to foreign buyers.
And if that happens, longer-term bond yields, which have a direct effect on mortgage rates, could head even higher, which would have the potential of making the credit crunch even worse.
With this in mind, Subodh Kumar, an independent market strategist said that the Fed and other central banks around the world would be better off pumping more liquidity into the financial markets instead of lowering rates.
The European Central Bank and several Asian banks have been injecting more cash into the markets this week and the Fed announced Friday it was committed to doing the same.
"The Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets," the central bank said in a statement. "The Federal Reserve will provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the Federal Open Market Committee's target rate of 5-1/4 percent."
Kumar said the Fed needs to be more level-headed than the stock and bond markets and that a rate cut would be an unnecessary knee-jerk reaction.
"Central banks have clearly provided liquidity to the markets this week and that's a separate issue than cutting interest rates," Kumar said. "The Fed will try to respond to these problems by providing more liquidity and that could calm markets down. I don't think the Fed should panic."