The darker side of interest rate cuts

NEW YORK (Fortune) -- Interest rates are headed lower. But how low can they go?

The Federal Reserve surprised Wall Street earlier this week by cutting its fed funds short-term interest rate target by three-quarters of a percentage point, to 3.5 percent. The move had the effect of reducing rates on mortgages and home equity loans, and reassured investors that the Fed will do what it can to spur economic activity as long as the threat of recession looms.

But as much as Fed Chairman Ben Bernanke might like to keep the economy rolling by slashing interest rates, it's not clear how much room he'll have to do so. Two factors complicate the outlook for further interest-rate cuts: the hefty losses in the financial sector that are making banks less eager to lend money, and the prospect that lower rates will chase overseas investors away from the dollar, lowering the value of the greenback and boosting inflation. Adding to the case against deep rate cuts is the widespread perception that it was the Fed's rate-cutting zealousness after the last recession that led to the housing bubble that now threatens to derail the economy.

For now, all those worries aside, the market expects to see interest rates go lower. Given the scale of losses tied to the collapse of the housing bubble - the decline in real estate prices in coming years could cut household wealth by $4 trillion to $6 trillion, according to some estimates - economists say it's understandable that the Fed is doing what it can to support growth.

Rising inflation "is not a factor restraining the Fed at the moment," says James D. Hamilton, professor of economics at the University of California, San Diego. He says the Fed views the current situation as "maybe a little scarier than the typical downturn" because of problems in the credit markets that threaten to starve businesses of capital needed to fund expansion.

Because of hefty losses on mortgage-related debt, banks like Citi (C, Fortune 500) and Bank of America (BAC, Fortune 500) have been raising billions of dollars just to boost their capital cushion for future losses. Setting aside bigger reserves means less money for lending to businesses and consumers.

That's why economists like David Rosenberg, chief North American economist at Merrill Lynch, expect the rate cuts to keep on coming. Rosenberg wrote Wednesday that he expects the Fed to cut the fed funds target by half a percentage point, to 3 percent, at the Jan. 29-30 regular meeting of its Federal Open Market Committee policymaking arm. If the Fed does as Rosenberg expects, it will have cut short-term interest rates by 1.75 percentage points in just four months, all in the name of defending an economy that so far hasn't dipped clearly into recession.

But that's not all: Rosenberg believes that in view of warning signs ranging from weakening employment data to soft manufacturing numbers, the Fed should keep on cutting. He is calling for the fed funds rate to fall as low as 1 percent, in a bid to limit the economic damage from falling house prices and tightening lending standards. A fed funds rate of 1 percent would match the low reached in the aftermath of the mild 2001 recession. "This may sound aggressive, but Fed easing cycles in recessions almost always see the prior tightening cycle completely unwind," Rosenberg writes. "The serious nature of the current housing deflation and credit crunch environment makes the case for an aggressive easing in policy all the more compelling."

Compelling as it may be, a rate-cutting policy may not always have the desired salutary effect; after all, Japan effectively had interest rates of near-zero percent for years without emerging from its economic gloom. And it carries its own costs. Lower rates boost the economy by making big purchases such as houses more affordable. They can also help banks rebuild their balance sheets, by enabling them to borrow at lower rates and lend at higher ones. But lower rates also tend to reduce the value of the dollar, which has already fallen sharply in recent years amid a surge in U.S. consumption funded by overseas borrowing. Further declines in the dollar raise the risk of boosting inflation, which hurts consumers by reducing their purchasing power.

Dean Baker, co-director of the Center for Economic and Policy Research in Washington, D.C., says the Fed's latest round of rate cuts risks adding to pressure on the dollar. He notes that unlike the Fed, the European Central Bank has been holding its interest rate target steady. So the latest Fed rate cut puts U.S. short-term interest rates, at 3.5 percent, below the 4 percent level of the euro zone. That differential tends to make the euro, which has already appreciated sharply against the dollar in recent years, even more attractive to investors shopping for places to put their money.

Indeed, currency analysts at Merrill Lynch wrote this week that they expect the dollar to fall further if the Fed continues to cut rates. The analysts write that they see dollar negatives in the "the erosion of the [dollar] as a safe haven, the lack of private sector buying, central bank flows and a widening interest rate differential." The worries about the strength of the dollar point to the Achilles heel of the U.S. economy: the fact that U.S. consumers have been financing their consumption by borrowing cheaply overseas.

At some point, observers warn, foreigners will stop wanting to send their money, which will drive up interest rates and hurt economic growth. "The ability of the financial authorities to stimulate the economy is constrained by the unwillingness of the rest of the world to accumulate additional dollar reserves," financier George Soros wrote this week in the Financial Times. "If federal funds were lowered beyond a certain point, the dollar would come under renewed pressure and long-term bonds would actually go up in yield. Where that point is, is impossible to determine. When it is reached, the ability of the Fed to stimulate the economy comes to an end." That's a worrisome thought indeed.

Meanwhile, Hamilton says that even with real estate prices poised to keep falling for some time, inflation worries can't be deferred forever. He says the Fed "may have to wrestle with that beast" down the road and warns that even if it's possible for the Fed to cut interest rates further, Bernanke and his colleagues should be careful about heading down the road toward 1 percent rates. "Anything below 2.5 percent would have me worried," he says. Cutting rates more sharply runs the risks of "sowing the seeds for the next problem" in the economy, Hamilton adds - very much as the Fed's low-rate policy during the recovery of 2003 and 2004 fed the housing bubble that is now deflating.

But he notes that keeping rates too low even as a recovery starts is an error that central bankers have been making for years, and will presumably continue to make, to everyone's chagrin. "This is a problem monetary policy has been making for half a century," he says.