Pressure mounting for big rate cut

Investors are betting that Federal Reserve chairman Ben Bernanke may cut interest rates by a half-point at the Fed's next meeting later this month.

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NEW YORK (CNNMoney.com) -- With unemployment rising to 5 percent in December and jobs growth coming in well below forecasts, economists said the Federal Reserve may be forced to slash interest rates when it meets later this month in order to stave off a recession.

In another step to combat the slowing economy, the Fed also announced Friday that it was going to lend up to $60 billion more to banks in two auctions later this month and that it would decide by Feb. 1 if it will conduct more auctions. The auctions are part of a plan the Fed announced in December to to try and restore order to the distressed financial markets.

But worries about a recession trumped the Fed's willingness to lend more money on Wall Street Friday. The Dow plummeted nearly 260 points, or 2 percent. The S&P 500 finished the day about 2.5 percent lower while the Nasdaq plunged 3.8 percent.

Bonds continued to rally, sending the yield on the benchmark 10-Year U.S. Treasury down to 3.86 percent. Bond prices and yields move in opposite directions and lower yields are typical during a sluggish economic environment.

The government reported December employment figures on Friday. Only 18,000 jobs were added to the nation's payrolls while economists were predicting job growth of 70,000. What's more, the unemployment rate was expected to come in at 4.8 percent, up from 4.7 percent in November.

As a result of these gloomy numbers, expectations for a half-point rate cut grew Friday morning. According to futures listed on the Chicago Board of Trade, investors are pricing in a 84 percent chance that the Fed will lower the federal funds rates by 50 basis points, to 3.75 percent, at the conclusion of its two-day meeting on January 30. There are 100 basis points in a full percentage point.

"The jobs numbers make a half point cut plausible," said Keith Hembre, chief economist with First American Funds in Minneapolis. "The unemployment rate has moved up to 5 percent from 4.4 percent last March and we've usually not had an upward movement of that magnitude outside of a recession."

Prior to the jobs report, investors were pricing in a 67 percent chance of a half-point cut as recession fears have grown in recent days. A report released Wednesday indicated that manufacturing activity is softening while oil prices, which hit $100 this week, have raised concerns that consumers may pull back on spending as a result of higher energy prices.

The Fed last cut the federal funds rate, a key overnight bank lending rate that affects rates for credit card debt, home equity lines of credit and auto loans, by a quarter-point to 4.25 percent on Dec. 11.

In the minutes from that meeting, released on Wednesday, the Fed hinted that more "substantial" rate cuts might be needed if the economy continued to show signs of weakness in the face of the credit crunch caused by last year's subprime mortgage meltdown.

John Lynch, chief market analyst for Evergreen Investments in Charlotte said that he thinks the Fed will now lower rates to at least 3.5 percent by mid-year. He said that despite the spike in oil and other commodities such as gold, the Fed would probably be more comfortable with inflation picking up a bit if it meant that the economy did not go into recession.

With the economy showing so many signs of sluggishness, it's going to be tough for the Fed to argue that inflation is the bigger bugaboo.

"There is no debate with the latest round of numbers. Everything points to a significantly slower economy," said Joe Balestrino, fixed income market strategist with Federated Investors in Pittsburgh.

Still, more rate cuts have the potential to lift oil and other commodity prices further since lower rates likely would further weaken the dollar. With that in mind, there are concerns that the Fed may not be as aggressive as Wall Street wants it to be.

"$100 oil is an unusual factor," Hembre said. "While it doesn't completely change inflation expectations it does complicate things a bit."

Nonetheless, investors are also worried that more rate cuts from the Fed may be too late to save the economy from dipping into a recession.

"A 50 point cut might not make that much difference in stopping a free fall if that is happening," said Oscar Gonzalez, economist with John Hancock Financial Services in Boston.

Gonzalez cautions that he thinks it's still too soon to say that the "sky is falling." But he would be worried if the jobs numbers for January are as bad as they were for December.

"If employment continues to weaken, we could be in for a very rough patch of economic news for at least the next few quarters," Gonzalez said.

Despite the weak numbers, economists said they did not think the Fed would hold an emergency meeting before Jan. 30 to talk about cutting rates.

Hembre said that it would take a "calamity" such as much weaker-than-expected retail sales figures for December or a lot more volatility in the stock and bond markets to justify an intermeeting move.

If there are more days on Wall Street like Friday, calls for a cut before the Fed's next meeting will increase. But Gonzalez suggested that a rate cut before Jan. 30 might actually cause stocks and bond yields to fall further since it could be construed as a sign of desperation by the Fed.

"An intermeeting move would be a cause for alarm," he said.

Instead, Gonzalez thinks the Fed is more likely to use creative ways to try to restore confidence in the markets and economy, such as the Term Auction Facility it announced last month in conjunction with central banks in Canada and Europe.

The Fed devised this proposal in order to encourage banks that need cash to ask for money without having to borrow directly from the Fed at the discount rate, which is higher than the federal funds rate.

The central bank has already loaned a combined $40 billion to financial institutions during two auctions last month. There was strong demand for these auctions and in both cases, the rates for the loans were below the discount rate of 4.75 percent.

The Fed said Friday it would hold its next auction, of up to $30 billion, on January 14 and that another auction of up to $30 billion would take place on January 28.

Balestrino is cautiously optimistic that a half-point cut, combined with the Fed's three rate cuts in 2007, could keep the economy from heading into a recession.

He adds that if the economy continues to slow in the next few months, the Fed could lower rates by a half-point at its March 18 meeting, or even at an unscheduled meeting in February.