As Fed Meets, Rate Cuts Draw Nearer

The change in outlook regarding monetary policy that might have been expected to occur tomorrow, when the Fed's monetary policymakers convene for their last meeting of the year, instead occurred today.

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Easing Talk Has Economists Worrying About Fed's Credibility

Based on an article today in The Wall Street Journal, economists and investors are increasingly convinced the Fed will lower rates at its first meeting of the new year, on Jan. 30-31. Some even believe the Fed may cut rates as early as tomorrow. The Fed sets the country's benchmark short-term interest rates.

The article said the Fed is considering skipping a step in the process that typically culminates in an interest-rate cut. Currently, the Fed's official viewpoint on monetary policy is that the risk of rising inflation is greater than the risk of too-slow economic growth. That equates to a preference for higher interest rates.

A first step toward cutting interest rates would be to declare the two risks in balance, indicating a preference for leaving interest rates at their current level. A second step would be to declare the risk of too-slow growth paramount, suggesting a preference for lower interest rates that would encourage consumers and companies to borrow more -- and spur growth. If the Fed were to take one step per meeting, it would not cut interest rates till March at the earliest. The Journal article said the Fed is considering jumping directly to the assessment that too-slow growth is the greater risk.

That disclosure makes a January interest-rate cut much likelier, even if the Fed ultimately opts for a risks-balanced statement tomorrow, some economists say. The fact that some policymakers -- possibly including Chairman Alan Greenspan -- are prepared to consider skipping a step shows that the Fed is closer to lowering rates than previously believed.

"There's more of a chance now they skip right over the neutral bias," says Christopher Low, chief economist at First Tennessee Capital Markets, referring to the risks-balanced statement. "I think what we're probably going to see is a neutral bias. But that doesn't rule out an ease in January."

The odds of a cut coming as early as tomorrow in the fed funds rate , implied by the prices of fed funds futures contracts, rose to 46% today from 41% on Friday.

A statement that too-slow growth is the greater risk would not be a surprise after the Journal article, agrees Daiwa Securities chief economist Michael Moran, who nonetheless is forecasting a risks-balanced statement. The switch "would suggest they are prepared to move interest rates in January."

The interest rate set by the Fed, the fed funds rate, has stood at 6.5% since May. Over the previous 11 months, the Fed raised the rate six times, starting from a low of 4.75%. The goal was to apply the brakes to economic growth, which was threatening to outpace the economy's potential. When economies grow faster than their resources are growing, shortages of goods and services can ensue. That causes prices to rise.

Now that economic growth has begun to slow, a growing chorus of market analysts and investors is calling for the Fed to reverse course and lower rates so that growth does not slow too much. Stocks, after all, have been beaten up, as company after company has warned that earnings will not be as strong as expected because sales have fallen.

The possibility rate cuts could come before the end of the first quarter started to win widespread acceptance after a Dec. 5 speech by Greenspan in which he acknowledged that the economy was at risk of slowing too much.

Concerns About Rising Prices

The danger in lowering interest rates -- and the reason why the Federal Open Market Committee , the Fed's monetary policy arm, might opt for a risks-balanced statement tomorrow -- is that lower rates could cause inflation to accelerate, even as growth is slowing. The risk of rising inflation has to recede further before the Fed can safely lower rates, economists say.

"We're beginning to see expectations of higher inflation creeping into people's thinking," First Tennessee's Low says. "If they ease too quickly, inflation could reaccelerate."

Rising inflation is still a risk, economists say, because the unemployment rate is very low, forcing some employers to offer high salaries to attract or retain workers. Wages that rise quickly can give workers the ability to buy more goods and services than the economy can produce, which can lead to higher demand and rising prices. As measured by the latest employment report on Dec. 8, the unemployment rate rose to 4% in November from a 30-year low of 3.9% in October.

At the same time, Low says, rising energy prices earlier in the year prompted many workers to seek and obtain larger raises than they otherwise would have been able to. Average hourly earnings, also measured by the employment report, grew at a rate of 4% in November, the fastest pace in nearly two years. From a monetary policy perspective, that statistic is "certainly not reassuring, and possibly troubling," Daiwa's Moran says.

And there is some evidence that wages are pushing prices higher too rapidly. As measured by the Consumer Price Index on Friday, the growth rate of prices of goods and services excluding food and energy was 2.6% in November, matching its fastest pace of the previous 12 months.

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It is possible for the Fed to acknowledge the risk of rising inflation while keeping its options open to lower rates in January, UBS Warburg chief economist Maury Harris says. It can declare the risks to the economy balanced, but craft a statement that emphasizes the evidence that growth is slowing. "I think it's going to say the balance of risks is no longer weighted toward inflation," he said. "Whether it's a neutral bias or an easing bias, when you read the language of the whole statement, it's certainly going to imply that easing is imminent."

The Fed pulled a similar stunt in its last statement on Nov. 15, Harris noted, declaring the risks weighted toward higher inflation, but crafting a statement that emphasized slowing growth. Strictly speaking, its bias was toward higher rates, but de facto, economists said, the Fed had moved to a neutral stance on interest rates.