Rates Seen Falling Again as Fed's Role Turns Defensive

The half-point cut expected Tuesday would bring rates to a 39-year low.
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The Fed is expected to deliver part two of its emergency stimulus package when the Federal Open Market Committee meets Tuesday.

Most economists are predicting another half-point cut in short-term interest rates, which would bring the rates to 2.5% -- their lowest level since the early 1960s. The last cut came between regularly scheduled sessions on Sept. 17, the day equity markets reopened following the Sept. 11 terrorist attacks.

Lately, the markets have needed all the help they can get, in light of both the attacks and an already anemic economy. But with eight rate cuts in the tank, some people are becoming skeptical about their benefit.

To the doubters, economists reply that things could be worse.

"Think about what the economy would be like if the

Federal Reserve had not been cutting interest rates," said Brian Jones, an economist at Salomon Smith Barney.

It would be wrong to think only of the stimulative aspects of aggressive monetary policy, some observers note. "The Fed is cushioning the downside," said David Orr, an economist at First Union. "It is,

for example, mitigating the effects of loan losses."

Among other practical implications of Fed easing, liquidity in the banking system has been maintained. Since Sept. 17, M1, a measure of U.S. money supply, increased by $115 billion. "People are not prevented from borrowing because interest rates are too high," said Orr.

Analysts agree, however, that monetary policy alone won't be enough to forestall further economic weakness. In the coming weeks, President Bush is expected to propose a fiscal stimulus package.

"In response to the new recession threat, fiscal initiatives of around $50 billion are now likely, on top of those already in place," wrote Richard Berner, an economist at Morgan Stanley, in a researchnote. "Using Fed models as rules of thumb, the cumulative stimulus by next year could add the equivalent of 7 percentage points to GDP."

In the meantime, the

fed funds futures contract -- a good proxy for monetary policy -- is pricing in 90% odds of a half-percentage-point reduction to interest rates on Tuesday. The threats to the economy from the events in New York and Washington include a steep drop in consumer spending and business investment spending.

"There's no doubt the Fed will cut by half a percentage point," said Anthony Karydakis, an economist at Banc One. "It would be imprudent todo anything less."