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Recession could be best medicine

Some economists, including one Fed member, say more rate cuts could be bad for the economy. But most expect Bernanke & Co. to slash rates again Tuesday.

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By Chris Isidore, CNNMoney.com senior writer

What are you most concerned about?
  • Your house
  • Your debt
  • Your job
  • Your savings

NEW YORK (CNNMoney.com) -- Two widely accepted beliefs about the upcoming Federal Reserve meeting Tuesday are that the central bank is worried about the country falling into a recession and that it will again slash interest rates sharply.

But should the Fed stop worrying and love a recession?

Several economists, including one member of the Fed's policy-making committee, have argued that more rate cuts are the wrong solution to spur economic growth. Some even believe a recession might be the best answer for the economy in the long term. That's still a minority view though.

Federal funds futures on the Chicago Board of Trade show investors betting that there is a 100% chance of at least a three-quarter percentage point cut at Tuesday's meeting, and a 52% chance of a full percentage point cut.

Even most critics of the Fed's rate cuts concede some additional cuts are certain Tuesday, especially since a report Friday morning showed that consumer prices held steady last month.

That's not to mention the fact that the Fed cut the rate it charges financial institutions by a quarter point Sunday, to 3.25%, as part of JPMorgan Chase (JPM, Fortune 500)'s proposed acquisition of Bear Stearns (BSC, Fortune 500) in an effort to prevent a collapse at Bear. That left just a quarter point difference between this rate and the 3% fed funds rate that policy makers will consider at the meeting.

If the Fed cuts as much as some expect, that would put its key federal funds rate at 2%, down from 5.25% when the Fed first began lowering rates six months ago.

Yet, it's not clear that the Fed cuts can do much to fix what ails the U.S. economy as it undergoes a credit crunch.

Too late for rate cuts to work?

There is a growing view among leading economists that the country is likely already in a recession that the Fed's previous rate cuts couldn't stop.

"The problems the markets are facing are not due to interest rates being too high. It's a lack of confidence," said Barry Ritholtz, the CEO and director of equity research for Fusion IQ.

Ritholtz and others arguing against more cuts say that only an economic slowdown can limit the inflationary pressures now building. They say that rate cuts are causing a sharp decline in the dollar that is feeding record prices for commodities such as oil and gold.

"The bottom line is that additional rate cuts are not going to help lenders trust each other and lend more," said Rich Yamarone, director of economic research at Argus Research. "They are just going to throw accelerant on a heated inflationary environment."

And perhaps more controversially, those calling for an end to rate cuts say that the business failures and other economic pain likely to accompany a recession are a necessary evil for the economy going forward.

Using low rates to try to ward off a recession is only likely to feed another asset bubble like the one in tech stocks in the 1990's or housing in the middle of this decade.

"What is this obsessive need to overturn the business cycle?" said Ritholtz. "You can end up preventing the market from following its normal course of clearing out the deadwood and letting healthy trees grow. The creative destruction of capitalism, that's what the Fed is working to prevent."

The Fed's inflation hawk is worried

One of the critics of Fed cuts is even on the Federal Open Market Committee that meets to decide interest rate moves. Dallas Fed President Richard Fisher, who was the only one to vote against the rate cut in January, has continued to talk loudly about inflation fears recently. He is widely expected to dissent against another rate cut.

In speeches in Europe last week, Fisher said talk that the Fed has adopted an "easy money" policy makes his "skin crawl" and that the Fed shouldn't be so afraid of a recession.

Fisher contended that he has one of the most bearish views of the economy of any member of the FOMC. But he doesn't believe that even a sputtering economy is justification to risk more inflation with further rate cuts.

"Our obligation is to prevent inflation in order to sustain long-term employment growth. I believe that the best way to cut through the treacherous economic waves that are upon us and keep our ship steaming forward is to stick to our purpose," Fisher told the Society of Business Economists in London on March 4.

And while Fisher did not explicitly mention the weakening dollar, he argued in a speech in Paris two days later that the global financial markets made it more important than ever for the Fed to show that is as concerned about inflation as other central banks around the globe..

"In today's world, where investors can move their funds instantly from one currency to another to avoid depreciation, the price central bankers pay for high inflation is much higher than in the past," he said.

Inflation fears growing

Tom Schlesinger, executive director Financial Markets Center, says he doesn't believe that Fisher is the only member of the FOMC who is worried about inflationary pressures.

"I think there are a few bank presidents actively concerned about inflation risks and will act as a minor brake on Fed cuts," he said. "I think the internal debates are going to be much more pointed going forward."

But Schlesinger said that rate cuts and other moves by the Fed to help pump liquidity into financial markets are necessary considering the weakness in the economy. And he believes Fisher is likely to be the only FOMC member to vote against the next rate cut.

"I have a hard time picturing Fisher being persuasive when the natural and justifiable inclination is to move quickly to put out the fire and to stand with the Fed chairman," he said. To top of page

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