Federal Reserve battles recession fears

Wall Street now expects Federal Reserve chairman Ben Bernanke and fellow Fed members to cut interest rates by at least a quarter-point on December 11.

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NEW YORK (CNNMoney.com) -- With oil prices approaching $100 and the yield on the benchmark 10-year U.S. Treasury note briefly dipping below 4 percent Wednesday, Ben Bernanke and his fellow Federal Reserve policymakers find themselves in a serious quandary.

On the one hand, the spike in oil prices could clearly be viewed as a sign of inflation. So that's a good argument for the Fed to keep its key federal funds rate unchanged when it has its next meeting on December 11, some economists say.

However, the spike in oil has the potential to lead to higher gas prices at the pump as well as steeper home heating costs this winter. With that in mind, $100 oil might be more of a tax on consumers and could weaken the economy.

"The economy is on the brink of a recession," said Mark Zandi, chief economist with Moody's Economy.com, an independent research firm. "Hand wringing about inflation is misplaced. The Fed should be focused on growth. Inflation is not an issue for 2008."

Falling bond yields also paint a gloomier picture of the economy, one of weakness. Bond yields typically fall when the economy is slumping. The yield on the 10-year has slipped from about 4.7 percent in mid-October to its current level. And the subprime mortgage crisis appears to be getting worse.

Several financial institutions, ranging from big mortgage lenders such as Washington Mutual (Charts, Fortune 500) and Countrywide Financial (Charts, Fortune 500) to more diversified banks like Citigroup (Charts, Fortune 500), Wachovia (Charts, Fortune 500) and Bank of America (Charts, Fortune 500), have been hit hard by rising delinquencies and mortgage investments gone sour.

The mortgage woes have also led to problems at prominent investment banks such as Merrill Lynch (Charts, Fortune 500) as well as Fannie Mae (Charts) and Freddie Mac (Charts, Fortune 500), the two government sponsored enterprises which play an important role in the home buying process since they are the largest purchasers and guarantor of residential loans.

The housing market may not turn around anytime soon either. To that end, the Fed lowered its economic growth forecast for 2008 Tuesday, citing weakness in housing.

And Treasury Secretary Henry Paulson told The Wall Street Journal Wednesday that he expected the potential number of mortgage defaults in 2008 to be "significantly bigger" than this year. This surprised some market observers since Paulson had previously been more upbeat about the outlook for next year.

"This is a significant change coming from Paulson given his optimism previously," said Ken Kim, an economist with Stone & McCarthy Research Associates, a fixed income and economic research firm based in Princeton.

As such, Wall Street now expects the Fed to cut rates by at least a quarter of a percentage point on December 11. What's more, investors are pricing in an 8 percent chance that the central bank will lower rates by a half of a percentage point, to 4 percent, according to fed funds futures listed on the Chicago Board of Trade.

The Fed cut its key federal funds rate, an overnight bank lending rate that influences what consumers pay on various types of loans, by a half-percentage point on September 18 and followed that with a quarter-point cut on October 31.

Still, some market observers and economists are debating what the Fed's next move really should be.

Drew Matus, an economist with Lehman Brothers, argues that the Fed should hold rates steady at its December meeting. He said the Fed needs to assert itself to Wall Street and show that it is more concerned about what's going on in the actual economy, not with stock prices.

"Yes, the financial markets are saying that the Fed needs to cut again. But if you look at the economy rather than the financial markets, the economy is in okay shape," he said. "Are we going to be rejoicing about the rate of growth? No. But it will be growth and not a decline."

According to the Fed's new outlook, the central bank is predicting that the economy will grow at between a 1.8 percent and 2.5 percent clip in 2008, down from an anticipated growth rate of 2.4 percent to 2.5 percent this year.

Phil Dow, director of equity strategy with RBC Dain Rauscher, also thinks that the economy is in reasonably decent shape.

"There is a disconnect. The economic reality isn't as bad as some are indicating," Dow said. A mentor of mine told me that real risk is at its highest when perceived risk is low. But right now, people are afraid of their own shadow. "

Dow argues that the recent volatility in the markets has more to do with hedge funds trying to lock in gains following a strong market rally from mid-August through late October and is not a sign that Wall Street now thinks a recession is imminent.

He added that once banks report their fourth-quarter results in January, which he believes will include a "kitchen sink" of charges and writedowns related to the mortgage meltdown, market sentiment may finally begin to improve.

Nonetheless, Dow thinks the Fed will, and should cut rates by a quarter-point. He thinks the Fed would send the wrong message, however, by slashing rates by a half-point.

"A half-point cut on top of all the negative news would just make things worse," he said.

But Zandi thinks a half-point cut is not out of the question, especially if stocks continue to decline. He also said the Fed might need to consider cutting its discount rate, a largely symbolic rate that determines how much banks pay when borrowing directly from the Federal Reserve, before the December 11 meeting.

The Fed did exactly that in August, lowering the discount rate by a half-point in an unscheduled meeting. It lowered the discount rate again in September and October along with the federal funds rate.

But there still is the issue of oil prices and the weak dollar. If the Fed continues to lower interest rates, that could help the economy by restoring confidence in the financial system, particularly the mortgage market.

It comes at a cost, however, as more rate cuts could put further upward pressure on oil and downward pressure on the dollar. That might be a risk the Fed needs to take though.

"Oil and the dollar could throw a monkey wrench in the Fed's plans but if you put everything together, rising oil prices should eventually crimp demand and that should keep inflation under wrap," Kim said.

"As for the dollar, it would weaken further with rates going lower but it's a consequence the Fed would have to accept because at the end of the day, the Fed is trying to promote maximum employment as well as stable prices," Kim added.

And Lehman's Matus said the weak dollar is actually having some big benefits. In fact, he believes that it might be what keeps the economy from slipping into a recession in 2008. He said that if consumer spending slows in 2008 because of the mortgage crisis and corporations also pull back on spending, robust exports to countries with stronger currencies could be the economy's salvation.

"The exports side is what saves us. One of the implications of the Fed cutting rates would be keeping exports up with a weak dollar," Matus said.

With that in mind, even though Matus does not think the Fed will cut rates in December, he does believe the Fed will lower rates several times next year, perhaps to as low as 3.75 percent.

But Stefane Marion, assistant chief economist with National Bank Financial in Montreal, said that as long as more bad news keeps coming out of financial institutions, the Fed should be even more aggressive.

"We're in unchartered territory because of what we are seeing with Fannie and Freddie. It is difficult to assess what the final end point is in this scenario," Marion said. He argues that the Fed could cut rates several times in 2008, bringing them perhaps as low as 3 percent by next summer.