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In case of emergency, slash rates

Some are calling for the Fed to cut rates sooner rather than later, since Wall Street thinks we're heading into a recession -- if we're not already in one.

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


NEW YORK (CNNMoney.com) -- The Federal Reserve may need to act aggressively to address growing fears of a recession even though it risks further spooking an already nervous Wall Street, according to some market observers.

Fed chairman Ben Bernanke said in a speech Thursday that the Fed was worried about the economy and that the Fed would take "substantive additional action as needed" to stimulate growth.

The Fed's next policy making committee meeting is a two-day session that is scheduled to conclude on Jan. 30. But some analysts think the Fed should cut rates before then.

In fact, investors are now pricing in a 100 percent chance that the Fed will cut the federal funds rate by a half-point, to 3.75 percent, according to federal funds futures listed on the Chicago Board of Trade.

Some believe the Fed's worries about inflation due to surging oil and gold prices and a weak dollar could keep it from cutting rates before Jan. 30.

But market experts said the Fed now has little choice but to cut its key federal funds rate later this month as recent economic reports have highlighted weakness in the manufacturing sector and disappointing jobs growth.

"In light of the shockingly weak economic statistics, the Fed has little choice other than to slash short-term rates," said Jeffrey Saut, chief investment strategist for Raymond James.

This week's market rout put stocks into official correction status. That also is likely to influence the Fed.

"The Fed will continue to lower rates regardless of what they say about inflation," said Quincy Krosby, chief investment strategist with the Hartford. "If this market continues to deteriorate and be underscored by a sell first and ask questions later mentality, the Fed may have no choice but to deviate from its gradual policy of rate cuts."

There have been gloomy predictions about the economy from two prominent investment banks -- Merrill Lynch said in a report earlier this month that the economy is already in a recession while Goldman Sachs said Wednesday that the economy is falling into one.

Investors also worry that more bad news from banks could lie ahead. They are bracing for a bad round of bank earnings beginning next week. Citigroup (C, Fortune 500), Merrill Lynch (MER, Fortune 500) and Washington Mutual (WM, Fortune 500) are all expected to report losses for the fourth quarter. Finally, retail sales figures for December will be released by the government next week - and they are not expected to be good.

Add all that up, and it's possible that the Fed may have to cut rates before January 30 to reassure jittery investors.

"With the stock market down, continued illiquidity in the credit markets and crummy financial numbers, that may almost force the Fed's hand," said Phil Dow, director of equity strategy with RBC Dain Rauscher.

The Fed has shown a willingness during the current credit crisis to act aggressively. It cut the discount rate, which is what banks pay to borrow directly from the Fed, by a half of a percentage point twice last fall.

Yet, some members of the Fed still seem divided about what to do next.

On Wednesday morning, Federal Reserve of St. Louis president William Poole said in a speech to a group of financial planners in St. Louis that it is "too early to tell right now" if the housing sector's woes will cause a recession and that the Fed continues to watch "both recession and inflation risks."

And according to a statement from the Fed released Tuesday, the twelve regional banks of the Federal Reserve had varying opinions about what the central bank's policy making committee should do with the discount rate, leading up to the Fed's meeting on December 11.

Directors of seven of the twelve regional banks voted to lower the discount rate by a quarter of a percentage point, to 4.75 percent. (There are 100 basis points in a full percentage point.) But directors of three banks voted for a 50 basis point cut and two banks voted for no change in the discount rate.

The Fed ultimately agreed with the majority of its regional bank presidents and cut its discount rate, as well as its federal funds rate, the overnight bank lending rate that affects how much interest consumers pay on a wide variety of loans, by a quarter-point on December 11.

Eric Rosengren, president of the Federal Reserve Bank of Boston, one of the banks that advocated a half-point cut to the discount rate before December 11, voted for a 50 basis point cut to the federal funds rate as well.

The Fed is taking steps beyond rate cuts to try and assuage liquidity concerns though. To that end, the Fed handed out $40 billion in loans to banks through two auctions last month and has plans to offer $60 billion more in loans through two auctions later this month.

Subodh Kumar, an independent market strategist, said creative steps like the auctions, and not big rate cuts, are the best way to address recession fears. He argues that a rate cut before January 30 or in an unplanned meeting between its January 30 meeting and next meeting on March 18 could make investors even more afraid.

"An intermeeting cut would be a signal of some kind of panic about growth," Kumar said. "The markets would fear that the Fed saw something even worse in the economy than that's what already obvious in the numbers that have been reported."

Raymond James' Saut agreed, saying that the market may initially approve of an emergency move but that cheers would turn to jeers once investors realized that an intermeeting cut might be a sign that the Fed is behind the curve.

But the Fed may have no choice, even if it risks agitating an already skittish market. The Hartford's Krosby said even if the Fed holds pat until January 30, it might need to make an emergency cut in February, especially if the employment numbers for January are weaker than expected.

"The rapid increase in the unemployment rate caught the market off guard. If we continue to see the unemployment rate tick up, it will be an issue of the Fed playing catch up," Krosby said.

RBC's Dow added that he's confident that the economy will either avoid a recession outright or at the very worst, only be in a brief recession. He thinks that the Fed's rate cuts from last year combined with more cuts this year will eventually stimulate growth.

"The word recession is rolling off the tongue of a lot of people and people are talking about a bear market. But recessions are less likely when the Fed's easing. I still think we'll muddle through this," Dow said.

Saut isn't so sure though. He said a recession may be a foregone conclusion given the weakness in the housing market and the fact that consumer debt levels are continuing to rise.

So even if the Fed's rate cuts and auctions help resolve the credit crunch, they might not help consumers all that much.

"The real question is whether the overspent/undersaved consumer is finally sated with debt," Saut said. "The Fed can stand on its head and blow soap bubbles out of its butt and that won't do anything."  To top of page

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