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Did the Fed go too far?

Wall Street loves the half-point rate cut as many believe it will keep the economy from slipping further. But some worry the Fed may have created more problems.

By Paul R. La Monica, CNNMoney.com editor at large

NEW YORK (CNNMoney.com) -- Did the Fed go too far by lowering the target on its key federal funds rate by a half of a percentage point Tuesday?

Investors apparently don't think so. But some observers expressed concerns that the initial euphoria is misguided and say that the cut papers over Wall Street's mistakes and could prompt a return to the reckless lending practices that caused the market's problems in the first place.

Do you support Fed policy makers' latest move on interest rates?
  • It's the right move
  • They should have cut rates more
  • They should not have cut rates
  • Not sure

Stocks surged following the announcement of the rate cut and the jubilation continued on Wall Street Wednesday as investors bet that the worst of the financial crisis created by the problems in the housing market may be over.

The Fed cut its federal funds rate, an overnight lending rate banks charge each other and that helps to determine the rates for many types of consumer loans, to 4.75 percent.

And the central bank indicated in its statement Tuesday that it will keep a close eye on the subprime mortgage mess and its spillover into other areas of the credit markets.

The market's interpretation: more rate cuts could follow later this year.

"It's a Pavlovian response. The shared experience of the past 30 years is when the Fed pumps money supply into the banking system and cuts rates, it always fixes things," said Jeffrey Saut, chief investment strategist for Raymond James.

Still, there is a debate as to whether the Fed was fixing a major problem or paving the way for a new one. Some argue that a big rate cut was the right move to ensure that the housing woes do not send the economy into a recession.

Others countered that lowering rates will justify bad behavior on the part of financial institutions who were burned by subprime loans and bring back an era of "easy money" and cause even worse pain down the road.

Brian Stine, a senior portfolio manager with Allegiant Asset Management Co. in Cleveland, believes the Fed made the right call, particularly since inflation does not appear to be that big of a concern. Reports released Tuesday and Wednesday showed that wholesale prices and consumer prices dipped in August.

"I wouldn't say a big rate cut was the wrong thing to do. And I don't think they did this to bail out borrowers and banks. The Fed was able to do cut rates because inflation pressures are coming down," Stine said.

But is inflation really no longer a problem? With oil prices above $80 a barrel and gold trading at its highest level in more than 25 years, some think inflation is still a big threat to the economy.

Stine argued though that the most significant contributor to inflation pressures is a strong labor market, not sky-high commodity prices. And with the job market showing signs of weakening, he thinks the Fed should not make inflation its most pressing concern.

Still, others think that the rate cut sets a dangerous precedent for Fed chair Ben Bernanke since it may give the markets the impression that he can be pushed around.

"This was a sad day for Bernanke," said one bond fund manager who asked not to be named. "He and other Fed members talked for a long time about how the financial markets were taking on too much risk. A quarter-point rate cut would have been enough to soothe the markets. This is just going to encourage more reckless risk-taking."

Along those lines, Oscar Gonzalez, an economist with John Hancock Financial Services in Boston, said he thought the Fed should have acted moderately and cut rates by only a quarter of a percentage point. He said that if the Fed continues to cut rates, it could reignite another real estate frenzy once the current mortgage problems subside.

"There is a real danger that we could have another housing bubble. And there is a risk that markets could become so exuberant that the Fed may have to raises rates much higher later on to cool things off," Gonzalez said.

He added that if the Fed cuts rates again, it should only be by a quarter of a point since that would leave the federal funds rate at 4.5 percent, or at the low end of what many economists feel is a so-called "neutral" level that would neither hinder economic growth nor stimulate a rapid overheating of the economy.

Another economist was not so sure that the days of exotic mortgages to people who clearly can't afford them are going to make an immediate return, however.

Ken Kim, an economist with Stone & McCarthy Research Associates, a Princeton, N.J.-based economic and fixed income research firm, said that interest rates are not nearly as low as they were earlier this decade when the Alan Greenspan-led Fed brought rates down to 1 percent.

Kim said the likelihood of the economy slowing in coming months will also crimp demand for borrowing. "Even with the rate cut, the economy is still going to enter a period of a protracted slowdown. With that in mind, aggressive lending practices probably won't return," he said.

Still, experts said that Wall Street, in its rush to celebrate Bernanke's rate cut, may be ignoring a key point, namely that the Fed may have felt the need to cut rates so drastically because the economy is in worse shape than thought.

"Somebody is pretty afraid of something," said Raymond James' Saut. "Clearly, the people who told us the credit crisis would be contained are wrong. It's spreading. Holding all things equal, there's more pain ahead."

Kim agreed. And even though he said the Fed was correct to cut rates, the markets may be fooling themselves by thinking that it is a panacea for the economy's problems.

"It was the right move to cut by a half point, but I also think the cut raises questions as to whether the difficulties in the economy are more severe than people think," Kim said. "We could get close to a recession. More easing from the Fed can help the markets psychologically, but for the economy, only time will really help."  Top of page