The Fed's unkindest cut?

NEW YORK (CNNMoney.com) -- The Federal Reserve is virtually certain to cut the target on a key short-term interest rate Tuesday. There is no mystery about that.

Still, there is a fair amount of intrigue surrounding the meeting. Specifically, economists are unsure about how much the Fed will lower interest rates.

According to futures on the Chicago Board of Trade, the market is pricing in a 100 percent chance of a cut to the federal funds rate, an overnight bank lending rate that heavily impacts how much interest consumers pay on their credit card debt, home equity lines of credit and car loans.

The fact that the Fed already cut its discount rate, which is what banks pay to borrow money from the central bank, in a surprise move on August 17, coupled with remarks from Fed members in the past few weeks about how closely they are monitoring the mortgage meltdown that is roiling the markets, makes it a virtual lock that Ben Bernanke and Co. will lower the fed funds rate on Tuesday.

The Fed cut the discount rate by a half of a percentage point, from 6.25 percent to 5.75 percent, on August 17, leading many market observers to speculate that the Fed would also lower the fed funds rate by a half of a percentage point on September 18.

To that end, as of September 14, investors were factoring in a 50 percent chance that the Fed will cut the fed funds rate by 50 basis points, or half of a percentage point, to 4.75 percent, on Tuesday.

But hopes appear to be diminishing somewhat for a big rate cut. Investors had been pricing in a 74 percent chance of a 50 basis point rate cut on September 12.

Still, what will happen if the central bank only lowers interest rates by a quarter of a percentage point? Fed watchers said it all depends on what the Fed says in its statement.

John Norris, director of wealth management at Oakworth Capital Bank, a private bank in Birmingham, Ala., said the market would probably not be too happy with just a 25 basis point cut at first. But he thinks that in some ways, a smaller rate cut might be more reassuring.

"Obviously everyone wants a 50 basis point cut. If it's only a quarter of a point the market will be upset," Norris said. "But if the Fed cuts by 25 basis points and the language in the statement is strong enough to indicate that this is the first of many cuts to come, cooler heads will prevail. Investors would like that as much, if not more, than a half-point cut with language that indicates this is just a one-off thing to placate the markets."

Scott Martin, managing director with Astor Asset Management, a Chicago-based investment firm with $200 million in assets under management, agreed that a half of a point cut might soothe the market at first...but not for long.

"If the Fed cuts by 50 basis points, you have to worry about the health of the economy. If the Fed can just say that they are going to keep an eye on the subprime market and signal that they may cut two more times by the end of the year, that might be the best case scenario," Martin said.

Vincent Boberski, portfolio strategist with FTN Financial in Memphis, also said that a half-point cut might get some cheers at first but it could wind up spooking the markets once investors realize the reason behind it.

"If the Fed were to cut rates by a half point, it might backfire since it could potentially give the market the impression that the economy is much weaker than investors thought," Boberski said.

Despite fears that the subprime mortgage market implosion could send the economy into a recession, fears stoked by the surprise decline in jobs during the month of August and a smaller-than-expected increase in retail sales, Norris points to other economic evidence that might prevent the Fed from cutting rates aggressively.

For one, oil prices hit $80 a barrel for the first time ever on Wednesday. That, as well as rising prices for other commodities, could keep the Fed from lowering rates by too much since it wants to keep inflation in check.

Norris added that the most recent figures from the Institute of Supply Management regarding manufacturing growth and services industry growth indicate that the economy is still expanding.

"Bernanke is in an awkward situation. Right now, the data is still mixed. And he doesn't want his reputation to be that financial markets are dictating monetary policy. He doesn't want to be known as the Fed chairman that was bullied around by Wall Street," Norris said.

David Joy, chief market strategist with RiverSource Investments, a Minneapolis-based asset management firm agreed, adding that the economy still does not appear to be in dire enough shape to justify a half-point cut.

"If the Fed cuts rates by a quarter of a point, you will hear howls from those who think the Fed is behind the curve," Joy said. "But in my mind, a quarter of a point cut is appropriate. I'm not sure the economy needs a half-point cut. Plus, the Fed could always lower rates further in the coming months."

Compounding matters though is that Bernanke's widely respected predecessor, Alan Greenspan, is currently making comments about the economy as he promotes his new memoir, which will be published on Monday.

That has led some on Wall Street to unfavorably compare how Bernanke is handling the subprime woes with how Greenspan dealt with numerous crises during his tenure, such as the 1987 Black Monday crash, the collapse of the hedge fund Long-Term Capital Management in 1998 and the September 11 terrorist attacks.

But according to an interview that aired on the CBS news show "60 Minutes" Sunday, Greenspan said that he felt criticism of Bernanke was unfair and added that his successor was doing "an excellent job."

Still, Greenspan's legacy has come into question lately as well. According to the "60 Minutes" interview, Greenspan admitted that the Fed did not fully grasp how much of a danger the explosion in demand for subprime mortgages would have on the economy.

Martin of Astor Asset Management pointed out that Bernanke might want to avoid cutting interest rates too drastically, since it can be argued that the historically low rates from earlier this decade helped bring about the subprime mess in the first place.

"The market is begging for a rate cut but we're trying to fix a liquidity problem with more liquidity. It's kind of funny," Martin said.

So while a half-point rate cut might be considered a quick cure for what's ailing Wall Street, some think it might be more pragmatic for the Fed to lower rates gradually.

"It would be a bold move to cut rates by a half of a point," Boberski said. "There is some justification for it since the labor markets are a lot weaker than people thought. But it seems like the Fed would prefer to take an incremental approach since Bernanke does not want to be seen as bailing out the financial system."

Joy added that it's amusing to see people criticize the Fed for not cutting rates since many Fed skeptics thought the central bank kept rates too low for too long.

"It's somewhat disingenuous to say the Fed needs to cut rates to bail out housing while at the same time many of these people were saying a year ago that the Fed needed to raise interest rates because the housing market was a bubble," he said.

To that end, Boberski thinks the Fed would rather cut rates two or three times by a quarter of a point before the end of the year and perhaps once or twice more in 2008.