Wall Street banks on another rate cut

NEW YORK (CNNMoney.com) -- After reading the minutes of the Federal Reserve's September meeting, many on Wall Street concluded earlier this month that the central bank would not cut interest rates at its next meeting, a two-day session that wraps up Wednesday.

The consensus then was that the Fed's half of a percentage point cut on Sept. 18 may have done the job to get the credit markets and economy back on track. Fed chair Ben Bernanke & Co. had everything under control.

What a difference a few weeks make.

Big writedowns at Citigroup (Charts, Fortune 500), Wachovia (Charts, Fortune 500), Washington Mutual (Charts, Fortune 500) and Merrill Lynch (Charts, Fortune 500), layoffs in the mortgage and investment banking businesses of Bank of America (Charts, Fortune 500), a spate of disappointing third-quarter earnings beyond the finance sector and $90-plus oil have sparked new concerns about the health of the economy.

The return of credit crunch and liquidity fears had some investors so worried that there were even unsubstantiated rumors floating around Wall Street Wednesday that the Fed might step in and cut the discount rate - a largely symbolic interest rate that determines what banks pay to borrow from the Fed - before its scheduled meeting.

Now, investors are betting that it is almost certain the Fed will lower the target on the federal funds rate, an overnight bank lending rate that influences how much interest consumers pay for credit card borrowing, home equity lines of credit and auto loans, on Oct. 31.

And even though embattled mortgage lender Countrywide Financial (Charts, Fortune 500), which on Friday posted a $1.2 billion loss in the third quarter, predicted a return to profitability in the fourth quarter, one market strategist said there could be more bank bombshells. That's likely to keep the Fed in easing mode.

"With all the subprime and credit issues, it looks like there will be more problems to come. Combine that with the backdrop of weaker economic growth and my guess is that the Fed will cut rates again," said Phil Dow, director of equity strategy with RBC Dain Rauscher.

According to futures listed on the Chicago Board of Trade, traders are pricing in a 90 percent chance that the central bank will lower the fed funds rate by a quarter of a percentage point, to 4.5 percent, and a 10 percent chance the Fed will keep rates unchanged.

And in the wake of a stronger-than-expected third quarter gross domestic product report Wednesday, there is a growing, albeit still small, sense that the Fed could or should pause instead of cutting rates again.

Keith Hembre, chief economist with First American Funds, said that the Fed's hands are tied. He believes the Fed would prefer to not cut rates, especially since the rising price of oil and other commodities like gold could add to inflation pressures.

But he said the Fed won't want to make matters worse in the credit markets by shocking Wall Street with no rate cut. So he thinks a quarter-point cut is likely.

However, Hembre added that the Fed will then try to draw the line. He believes the central bank will say in its closely-watched statement that it is still worried about inflation - in an effort to convince the market that there may not be many, or any, more rate cuts in the immediate future.

"Fed members don't want to contribute to volatility in the market. And to the extent that the market is expecting a move, if a rate cut doesn't happen they would do that," Hembre said. "But they have other considerations as well."

David Wyss, chief economist with Standard & Poor's, also thinks the Fed will cut rates. He does not think the central bank needs to be as concerned about inflation as it does about the possibility of weak consumer spending ahead of the holidays.

But he added that the Fed may want to cut rates once more - sometime soon - to ensure that the economy does not enter a recession in 2008.

"I think if they just do a quarter-point cut, they will leave the door open for more rate cuts in December or January," he said.

After the October meeting, the Fed's next meeting is scheduled Dec. 11. Its first meeting of 2008 is a two-day session that concludes on Jan. 30.

Still, hopes for a big rate cut have quickly dimmed. As recently as late last week, investors were pricing in a 14 percent chance that the Fed will take drastic action, as it did in September, and cut rates by half a percentage point, to 4.25 percent.

Wyss said that the Fed could comfortably lower rates to 4 percent without having to worry about a return of the "easy money" type of lending that got the financial services sector into this subprime mortgage mess in the first place.

Another market strategist pointed out though that the Fed needs to be careful.

"I don't think a second rate cut will be harmful, but I'm not entirely sure it will be particularly helpful in the long run either," said Steven Bleiberg, president and chief investment officer of Legg Mason Global Asset Allocation. "Cutting rates doesn't necessarily help clear up a bad debt problem, and can sometimes increase the likelihood of starting another asset bubble in some other area of the economy."

But Wyss argued that a fed funds rate between 4 percent and 4.5 percent would be in the so-called "neutral" range that should neither promote excessive growth and runaway inflation nor grind the economy to a halt.

Nonetheless, it is impossible to predict what the Fed might do in the coming months since it is not clear just how severe of an impact this summer's credit crisis is having on the economy.

"The Fed will be watchful of economic numbers. If the job numbers get better between now and December maybe they don't need to cut again," RBC's Dow said. "But we just don't know how much damage has been done yet."