Fed: 2 tough decisions

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What should the Federal Reserve do about interest rates at Tuesday's meeting?

• Cut rates by a half percentage point
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NEW YORK (CNNMoney.com) -- Investors are anticipating that the Federal Reserve will cut interest rates for the third consecutive time at its next meeting on Tuesday, as Wall Street continues to grapple with concerns about the housing market and fears of a recession.

An employment report issued Friday, which showed that job growth in November slowed yet exceeded forecasts, did little to change the perception that a cut is in the works. So the issue remains whether Fed chair Ben Bernanke & Co. will lower rates by a quarter of a percentage point or half of a percentage point.

Well, how about both?

When the central bank's Open Market Committee meets to discuss monetary policy, members actually have two decisions to make - one about the federal funds rate and one about the discount rate. Some suggest that the Fed may cut the fed funds rate by a quarter point and lower the discount rate by a half point.

The fed funds rate gets most of the attention from Wall Street since it is the overnight bank lending rate that has a direct impact on how much interest consumers pay on credit card borrowings, home equity lines of credit and car loans. The Fed lowered this rate by a quarter-point on Oct. 31, to 4.5 percent.

The central bank also lowered its discount rate, which is what banks pay to borrow directly from the Fed, by a quarter-point at its last meeting. Changes in the discount rate have been viewed as symbolic, but the rate has taken on increased importance in the wake of the subprime mortgage crisis wreaking havoc on financial services companies and Wall Street.

According to federal funds futures on the Chicago Board of Trade, investors are evenly split on whether the Fed will lower the funds rate by another quarter point to 4.25 percent or reduce it by a half-point, to 4 percent.

But some argue the Fed does not need to lower the fed funds rate by a half point, as it did on Sept. 18.

Despite fears that Wall Street's credit crunch is spreading and possibly leading to a recession, little evidence exists to suggest that the economy will actually stop growing in 2008.

The Fed has predicted a slowdown in growth, to be sure, but not declines in gross domestic product. Many economists share this view. And the November jobs report, which showed that unemployment remained steady at 4.7 percent and that employers added 94,000 jobs, supports the notion that the economy is still in relatively healthy shape.

"The jobs numbers were not shabby. It seems a safe bet that the economy is not going to fall apart rapidly," said Oscar Gonzalez, economist with John Hancock Financial Services in Boston. "The numbers were very important. It should allow the Fed to cut rates by 25 points and not 50," he said.

The big worry about a lower fed funds rate is that it could spark more consumer borrowing. And if consumers have easier access to so-called cheap money, that could exacerbate the problems that got borrowers and banks in this mess in the first place - that too many people got loans they couldn't afford.

That said, the Fed is not likely to ignore the massive number of writedowns that big banks and mortgage lenders have been taking in the past few months because of exposure to loans made to subprime borrowers.

"If you look at what's been the driver for the Fed the past couple of meetings, it hasn't been as much as the economy as it has been what's going on in the financial markets," said Brian Stine, senior portfolio manager with Allegiant Asset Management Co. in Cleveland.

"You could see the Fed drop the fed funds rates by 25 points and cut the discount rate by 50. That would enable banks to borrow at lower rates without affecting the rest of the economy," Stine added.

After all, the Fed lowered the discount rate by a half point on Aug. 17 following an unplanned meeting and followed suit with another half point cut on Sept. 18.

Richard Yamarone, chief economist with Argus Research Corp., also thinks the Fed needs to consider the fact that Wall Street's woes aren't necessarily having a big impact on Main Street.

"The consumer is not crying out for lower interest rates and stimulus - it's the financial sector and the markets," Yamarone said. "Cutting the discount rate by a half point could work. That's justified. But it would be a big stretch to slash the fed funds rate."

Yamarone pointed to the fact that consumer spending during the holidays has not taken the big hit so far that many feared.

"Everyone, the Fed included, is underestimating the resilience of the consumer. That would be a big mistake," he said.

But Jim Glassman, senior economist with J.P. Morgan Chase, argued that the Fed risks falling behind the curve if it doesn't cut both the fed funds rate and discount rate by a half point.

"It's not about the economic news now. It's all about the danger that lies ahead of us with a credit system that's far tighter," Glassman said. "The message the Fed needs to send is that it will do what it takes. If the economy slows down as most economists think, the Fed will want to get ahead of that."

Still, even if the Fed decides to be less aggressive and cut the fed funds rate by only a quarter of a point, that might not necessarily mean that the central bank will be done reducing rates.

For what it's worth, Wall Street is banking on more rate cuts at the central bank's first three meetings in 2008, which will take place in January, March and April. The fed funds futures are pricing in a fed funds rate of 3.75 percent by May, three-quarters of a percentage point lower than current levels.

Stine said he believes the Fed probably doesn't want to lower rates further but that might not be possible if mortgage delinquencies and defaults keep rising and housing prices fall.

"I think the Fed is hoping this is the last rate cut, that once we get past this financial crisis, they'll be back on inflation watch. But it depends on how the housing market plays out," he said.