Fed to Choose Its Economic Stimulus Weapon: 25-Caliber or 50?

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This Rate-Cut Show Drawing Huge Ratings

The Case for a Half-Point Cut

Don't Second-Guess the Fed, Kids

Ideologues be damned. Handicapping the outcome of Wednesday's Federal Reserve meeting is a triumph of the mushy middle.

The Fed will announce its decision on interest rates at about 2:15 p.m. EDT Wednesday, the second day of its two-day meeting. It's a virtual guarantee the policy-making body will cut interest rates for the sixth time since the beginning of the year, when the fed funds rate stood at 6.5%. What's unknown is whether it'll cut the rate, currently 4%, by a quarter-percentage point or a half point.

While economists on both sides concede there's good argument for either outcome, the prevailing mood has shifted toward expecting a half-point cut. The fed funds futures contract, the bond market's proxy for predicting Fed policy, falls somewhere between expecting a 25 basis-point and a 50 basis-point drop.

Currently, 15 of the 25 primary dealers in government securities figure the Fed is going to cut by just a quarter point. The remainder are looking for a half point, and that number has been increasing in the last two weeks. Those on the side of 50 basis points don't see any reason, not even inflation, that the pace of cuts should slow; those thinking 25 figure it's about time the Fed started downshifting.

But the more aggressive folks don't see much persuasive evidence the Fed should slow its pace of rate-cutting, which has come in half-point increments since the reductions started on Jan. 3.

"Why at this meeting would you downshift the speed of cuts?" asks Ethan Harris, chief economist at Lehman Brothers, betting on a half point. "There's nothing in the data flow that suggests we're beginning to see a turn in the economy."

Save for the consumer, the latest data show the economy is continuing to deteriorate. The most recent industrial production report, for example, shows industrial capacity utilization at its lowest level since 1983 (not good). And the earnings outlook for companies is in poor shape, something the Fed's been particularly attuned to in the last several months.

The Fed isn't to blame for ongoing sluggishness. It takes between six and 12 months for interest-rate cuts to work their magic on the economy (and rates arguably were still restrictive on the ability of the economy to grow in February, even though the Fed already had cut twice). Economists believe the Fed is decisively in favor of lowering rates until there's real improvement -- rather than assuming there will be a rebound because of its earlier efforts.

Paying Attention

Some believe the Fed is trying to tackle too many problems that are out of its control, including the lack of business investment, the overhang of inventory, high energy costs and whatever else the Fed has thrown into the mix. Yet there's concern it's ignoring a growing problem of inflation.

"We're worried the Fed is really trying to overmanage the economy," says Mickey Levy, chief economist at Bank of America. "It's a concern to us the Fed has eased so aggressively when saying inflation is well contained. We're hoping they do 25."

Some board members, such as Governor Lawrence Meyer, have pointed out in recent weeks the possibility the Fed could overshoot and let inflation leak into the economy because lower rates pump up demand for goods and services. The core rate of inflation as measured by the Consumer Price Index is rising at a 2.5% annual rate, down a bit from a few months back. But prices of services are increasing. As of May, medical and housing costs were both rising at a 4.6% annual rate. The Cleveland Fed's closely watched median CPI is also running high -- currently 3.9%, up from 3.1% a year ago (though down from an earlier peak).

It's become clear in the last six months that the Fed is attacking recession first and worrying about inflation later. Alan Greenspan has cast his lot with avoiding recession -- recently stating that inflation is not a problem, which strikes Levy and others as a bit fanciful.

The activism shown by this Fed leads some economists to believe the Fed would reverse course forcefully later this year if growth gets back on track and inflation continues to rise.

"They have a dual mandate that shapes how they do things," says Diane Swonk, chief economist at Bank One. "This Fed has decided to hedge risks. They've never hedged risk this much -- this is the most aggressive easing in a short period of time; that means they have to be vigilant about taking it back if necessary."

Puny Earthlings

In the end, quite a number of market folks say they'll be satisfied with either a 25 basis-point or a 50 basis-point cut. The Fed, after all, isn't going to alter its course of tackling the slowdown as a result of this meeting alone, so the actual amount it cuts is perhaps less of an issue than its ultimate goal.

Should the Fed cut by 25 basis points, there's a good likelihood the statement that accompanies its decision will lay out the belief current economic risks are weighed toward further weakness. If it cuts 50 basis points, the statement probably will be muted, mollifying those who think the Fed is moving too quickly.

Ultimately, the quarter-point differential may not matter for much more than a few hours -- once the verdict is in, the market again will busy itself with waiting for the next rate cut.