Fed to investors: More cuts coming

Ben Bernanke and the Federal Reserve signaled that more interest rate cuts are coming.

NEW YORK (CNNMoney.com) -- The Federal Reserve hinted Wednesday in minutes from its latest meeting that more interest rate cuts might be needed if the deterioration in the credit markets leads to deeper problems for the housing sector and overall economy.

But the news from the Fed on Wednesday did little to soothe Wall Street, which kicked off 2008 more concerned about a recession and rising inflation. The Dow fell more than 220 points, or 1.7 percent, while the S&P 500 and Nasdaq fell 1.4 percent and 1.6 percent, respectively.

The central bank lowered its key federal funds rate - an overnight bank lending rate that affects how much consumers pay for credit cards, home equity lines, auto loans and other forms of credit - by a quarter of a percentage point on Dec. 11 to 4.25 percent.

That marked the Fed's third consecutive rate cut since September as the central bank attempts to deal with the subprime mortgage meltdown, which has caused cash-strapped consumers to default on their loans and banks to report billions of dollars in losses tied to bets on bad mortgages.

In the minutes, the Fed said that "some members noted the risk of an unfavorable feedback loop in which credit market conditions restrained economic growth further, leading to additional tightening of credit" and added that "such an adverse development could require a substantial further easing of policy."

As such, traders are now betting that a rate cut at the Fed's next meeting, a two-day session that concludes on Jan. 30, is certain. The question is simply how big of a cut it will be.

According to futures listed on the Chicago Board of Trade, investors are pricing in a 100 percent chance that the Fed will lower the federal funds rate by another quarter-point to 4 percent and a 63 percent chance that the central bank will lower rates a half-point to 3.75 percent.

One economist said there is a growing sense that even continued rate cuts won't cure what's ailing the market.

"I'm not sure if we can judge that it's too little too late, but what is clear is that there are more things to be nervous about, such as more writedowns from banks and weak holiday sales," said Tom Higgins, chief economist with Payden & Rygel, a Los Angeles-based money management firm.

"People are factoring in a higher risk of recession and that's weighing on the market, even with expectations that the Fed will be accommodative," Higgins added.

A report by the Institute of Supply Management released Wednesday morning indicated that manufacturing activity declined in December. Economists had been expecting a slight increase in manufacturing.

"The manufacturing numbers are a classic case of fears spreading about the health of the economy," said David Kelly, chief market strategist with JPMorgan Funds. "American businesses are getting scared of a recession and that is pushing the market down."

What's more, oil prices spiked to above $100 a barrel Wednesday before settling at $99.62 due to violence in oil-rich Nigeria and concerns about Mexico possibly halting exports of oil because of bad weather.

But traders were also worried that more rate cuts will lead to even higher oil prices since rate cuts could further weaken the dollar, which would put upward pressure on the price of oil, gold and other commodities.

Kelly said, however, that rising oil prices are not a reason to worry about inflation. If anything, he said, higher energy prices could be yet one more thing that could slow the economy down. He pointed to the action in the bond market as proof.

Bond prices surged Wednesday, sending the yield on the 10-year Treasury to 3.9 percent. Bond prices and yields move in opposite directions and lower yields are usually associated with times of economic weakness. So $100 oil could be another reason that the Fed should lower rates further, he said.

"$100 oil is adding to recession fears more than inflation fears. The 10-year treasury is now well below 4 percent. Oil is not a double-edged sword, it's a single-edged sword," Kelly said.

Higgins said the next big data point for investors to focus on will be the December employment report, which will be released on Friday morning.

According to a forecast on Briefing.com, economists believe that 70,000 jobs were added to the nation's payrolls and that the unemployment rate crept up to 4.8 percent from 4.7 percent in November.

The markets, already worried about a recession, could panic if the December labor figures are much worse than the forecasts.

"Investors are sitting on pins and needles worrying about weaker than expected numbers for the jobs reports," Higgins said.

Craig Hester, chief executive of investment firm Hester Capital Management, an Austin, Texas-based firm with $1.5 billion in assets under management, said he thinks the Fed will be watching the jobs numbers closely and could feel moved to lower rates by a half-point.

"The economy will trump inflation. If the Fed really gets worried about growth, they will take a bigger step with rates," Hester said.

The Fed, in addition to cutting rates, has also taken steps to address the credit crisis by setting up a so-called Term Auction Facility, a series of temporary loans to banks that need funding. The central bank, in conjunction with central banks in Canada and Europe, have already conducted two auctions of $20 billion apiece.

However, according to an addendum to the Fed minutes, some Fed members expressed doubts about whether the auction would really address the biggest problems facing banks.

"A few participants, however, questioned the need for and the likely efficacy of the proposal, expressed concerns about the longer-run incentive effects of a TAF, and felt that the possible drawbacks could well outweigh any benefits," the Fed said.

Fed members held a conference call on Dec. 6 to discuss the proposal for the Term Auction Facility and approved the proposal on Dec. 10. The specifics of the auction were formally announced on Dec. 12.

But Hester thinks the auctions have helped provide funds at attractive rates for big banks that needed cash. What's more, he said that the credit crisis may not wind up having as big of an impact on the overall economy as some fear.

"The economy is without question going to slow, but this seems to be more of a large bank issue than a wider credit crunch," Hester said.