Fed: Don't panic. We're here

NEW YORK (CNNMoney.com) -- When the Federal Reserve met on Aug. 7 and decided to leave a key interest rate alone, the central bank didn't appear overly concerned that problems in the subprime mortgage market would have a major impact on the broader economy, according to minutes of the meeting released Tuesday.

"Credit conditions for investment-grade businesses and prime households were relatively little affected by the market turbulence," the Fed noted in the minutes, adding that it "saw moderate economic expansion in coming quarters."

Of course, the Fed changed its tune a bit just 10 days later, as the credit crisis deepened. The Fed, on Aug. 17, cut the rate it charges banks for loans by half a percentage point, citing financial markets that had "deteriorated" as well as "tighter credit conditions and increased uncertainty." The so-called discount rate is a less powerful lever than the central bank's fed funds rate, which affects rates on many consumer loans and so far remains untouched.

But the Fed also acknowledged in the minutes from the Aug. 7 meeting that it might be forced to cut rates.

"The recent strains in financial markets posed additional downside risks to economic growth. Members expected a return to more normal market conditions, but recognized that the process likely would take some time, particularly in markets related to subprime mortgages," the Fed said.

"However, a further deterioration in financial conditions could not be ruled out and, to the extent such a development could have an adverse effect on growth prospects, might require a policy response. Policymakers would need to watch the situation carefully," the Fed continued.

With all that in mind, what's the most likely next move for the Fed?

Some have argued that the cut to the discount rate, combined with an injection of billions of dollars of cash into the banking system in recent weeks, have helped to stabilize financial markets.

That said, most investors still expect the central bank to cut the fed funds rate when it next meets on Sept. 18. The fed funds rate is an overnight bank-to-bank lending rate that affects rates on credit cards, home equity lines of credit and other consumer loans.

"My guess is that there will be increased pressure on the Fed to cut rates but it sounds like they may be reluctant to do that," said Phil Dow, director of equity strategy with RBC Dain Rauscher in Minneapolis. "But if credit problems prevail for some time, there is no question it will impact the economy."

The Fed has held the fed funds rate steady at 5.25 percent for its past nine meetings. But according to fed funds futures traded on the Chicago Board of Trade, investors are betting that a quarter-point rate cut is all but certain at the Sept. 18 meeting. What's more, investors are pricing in the strong likelihood of a second quarter-point cut before the end of the year.

Stocks, which were trading sharply lower before the minutes were released, fell further after they came out. The Dow wound up falling more than 280 points, or 2.1 percent, while the Nasdaq and S&P 500 each declined by about 2.4 percent.

Chris Probyn, chief economist with State Street Global Advisors in Boston, said the market might have surged based on what was in the Fed minutes, particularly the language about a possible "policy response," if the Fed had not already cut the discount rate. In other words, the minutes are kind of old news in light of the discount rate cut.

"Had it not been for the new policy statement issued on Aug. 17, which kind of makes this ancient history, this would have caused a stir. The market would have reacted more positively," Probyn said.

Nonetheless, Probyn thinks the Fed will cut rates at both its September and October meetings. In fact, Probyn said he would not be surprised if the Fed cut rates by a half of a percentage point in September in order to reassure Wall Street.

James Glassman, a senior economist with J.P. Morgan Chase, also said the Fed might need to cut rates more aggressively.

"I think the issue now is not a rate adjustment but what's the style and how many. This is a historic event and it may require a forcible response by the Fed," Glassman said.

Another economist said that investors might be disappointed by the minutes since they showed that the Fed did not truly understand how drastic credit problems were.

"The committee misjudged the severity of the financial storm that they were in the middle of. They saw signs of distress but not to the degree that has transpired," said Mark Zandi, chief economist Moody's Economy.com.

As such, Zandi predicted the markets probably won't regain confidence in the Fed until it cuts the fed funds rate, even though he thinks the Fed made the right move cutting the discount rate.

"The Fed has acted appropriately since the Aug. 7 meeting and they have proven since then that they do understand the problem. But investors won't feel good until we get a rate cut," he said.

Glassman agreed that even though the market is already widely banking on a rate cut, investors are not going to be satisfied until it actually happens.

"Days like today are a reminder that every time you think things are settled down, they are not. The markets not going to be able to settle down until investors understand where the Fed is heading," he said.

But even a rate cut might not be enough to soothe investors. The Conference Board reported Tuesday that its consumer confidence index posted its biggest monthly drop in nearly two years.

What's more, another report released Tuesday showed that housing prices nationwide dipped more than 3 percent in the second quarter from a year ago.

"The signal from stocks is that maybe the economy is going to slow down," said Steve Van Order, chief fixed income strategist with Calvert Funds in Bethesda, Md. "The markets could be concerned that a rate cut may be too little too late. The market is certainly sending a message that it is very worried right now."