Fed rate cut? Don't bank on it
Investors betting a Fed rate cut is a lock could end up getting badly burned.
NEW YORK (CNNMoney.com) -- Investors who are counting on the Federal Reserve to cut interest rates sometime in the next month may end up badly disappointed.
The credit crunch of the past month has convinced many on Wall Street that a cut in the central bank's key short-term interest rate is basically a lock.
Stocks jumped Friday after the Fed announced a surprise cut in the little used discount rate that the central bank charges on loans made directly to banks - and again on Tuesday on bets the Fed will cut its other key rate, the fed funds rate, by the central bank's next meeting on Sept. 18, if not beforehand. The fed funds rate is the more important rate since it affects many consumer loans.
But a number of economists believe that the Fed will hold rates steady next month.
"The Fed would like to do everything possible under the sun but make a cut in the fed funds rate," said Bernard Baumohl, an economist and author of the textbook "The Secrets of Economic Indicators."
The Fed had raised rates 17 times over two years to get the fed funds rate to 5.25 percent in an effort to keep the economy from overheating and letting prices get out of hand.
But the easy credit available during the 15 months that the funds rate stood at only 1 percent helped spark a housing boom and rapid growth in risky mortgage products.
A host of economic readings are due between now and Sept. 18, including the August jobs report, a survey of manufacturing executives, sales by major retail chains and a number of key inflation readings.
Baumohl said that before the Fed will move to cut rates, it will need to see some new signs of weakness in consumer spending or employment. He does not believe the turmoil in the credit markets alone will be enough to convince Fed Chairman Ben Bernanke and other Fed governors to cut rates.
"He very much believes the main job of the Fed is to control prices and inflationary expectations," said Baumohl "He wants to be viewed as a chairman vigilant in not letting prices get out of control. It all depends on what economic indicators point to from this point on. Assuming nothing else changes, I do not see the Fed cutting rates, even on the 18th."
Still, some economists believe the turmoil in the credit markets poses a severe enough threat to the economy that the Fed could move to cut rates even without further signs of economic weakness. But even some economists with that view concede the Fed would prefer to stay put, given the opportunity to do so.
"I think Bernanke still feels this is a financial markets issue, this is not an issue for the overall economy, and that financial market illiquidity should be addressed by opening the discount rate liquidity window, not with by cutting the fed funds rate," said David Wyss, chief economist with Standard & Poor's.
But Wyss argues that a Fed cut is nevertheless justified, even without other signs of weakness.
"Even if he's right, and this is a microeconomic issue and not a macroeconomic issue, I think the Fed is better served being out ahead of the problem than waiting for it to occur," said Wyss.
But several economists said there are big risks for the economy, and even for the financial markets, if the Fed blindly follows market expectations and cuts rates despite fresh signs of economic strength. One problem could be a continued slide in the value of the dollar, which could spark inflation by making some imports more expensive. It also could lead to a sell-off in the Treasury bond market on expectations of a jump in inflation.
"If the Fed does cut, it will be inviting serious inflation pressure that could send the long-bond yield skyward," said Rich Yamarone, director of economic research at Argus Research. "That could cause serious problems for mortgage rates, that would trigger the resets [of adjustable-rate mortgages], and then you've got the calamity you're looking for."
Major U.S. stock indexes have essentially hung onto the gains they posted on Friday. Art Hogan, the chief market strategist for Jefferies & Co., said he's worried that the stocks will sell off if they don't get the rate cut investors are now expecting.
"I think the market is making what may turn out to be an irrational assumption, that the Fed has decided to do something they haven't been inclined to do yet," said Hogan. "Investors are hell-bent to believe they're going to cut and they're trading like it's already happened."
Wyss and the other economists said that if the Fed is leaning toward leaving rates unchanged, Bernanke and other Fed policymakers have plenty of time to signal to the markets that there is no rate cut in the works.
"This opinion [of a rate cut in the works] can change on a dime, and it will," said Wyss. "Two weeks ago the markets were convinced the Fed wouldn't move until March. It can change back just as quickly. The lesson from the problems we saw under [1970's Fed chairman Arthur] Burns is you want the markets to know ahead of time. Greenspan was very good at telegraphing it and Ben learned Morse Code from him."
But Hogan and others said there there is likely to be another sell-off in stocks if and when investors become convinced they aren't getting a hike.
"Back in March 2006, the market became convinced the Fed was done raising rates when it reached 5 percent. It got ugly when they realized they were going to 5.25 at the next meeting. We could see that again."