Skip to main content

The market expects yet another rate cut from the

Federal Reserve

on Wednesday, as the central bank weighs other policy changes that would allow it to inject more liquidity into the banking system.

Investors were recently pricing in an 80% chance that the Fed cuts its key, short-term interest rate target by a quarter-point on Wednesday, which would bring it to 2%. Some observers expect the central bank to

pause its rate-easing campaign

after its April meeting as financial markets ponder the limits of easy-credit policies amid rising signs of inflation.

The specter of global inflation has heavily influenced the shift in expectations on Wall Street. Two weeks ago, the market was priced for 40% odds of a 50-basis point cut, which would have brought the Fed's key short-term interest rate target down to 1.75%. A month ago, the market saw 100% odds of a 50-basis point cut and 64% odds of a 75-basis point cut.

The Fed has slashed its rate target by 300 basis points since the outbreak of the credit crisis last summer. Still, widened credit spreads only began to narrow after the Fed aided

JPMorgan Chase's

(JPM) - Get JP Morgan Chase & Co. Report

purchase of

Bear Stearns

( BSC), which was on the brink of bankruptcy in mid-March, and extended credit to Wall Street investment banks like

Goldman Sachs

(GS) - Get Goldman Sachs Group Inc. (The) Report


Scroll to Continue

TheStreet Recommends

Lehman Brothers

( LEH) and

Merrill Lynch

( MER) through a series of new lending facilities under authorities the central bank had not exercised since the Great Depression.

The implicit government backing of investment banks and mortgage giants like

Fannie Mae

( FNM) and

Freddie Mac

( FRE) also was welcomed by financial markets.

The Fed is looking at new ways to empower itself to step in and address liquidity issues it has faced during the credit crunch. It said on Monday that its Federal Open Markets Committee will discuss paying interest on commercial bank reserves held at the Fed, a move that could lead to banks holding larger reserves at the central bank, expanding its balance sheet and allowing it to extend more credit to banks in exchange for less-liquid assets, like mortgage-backed securities.

The Fed got permission from Congress to pay interest on reserves starting in October 2011 under a 2006 law. It would require an act of Congress to begin paying interest on bank reserves sooner than that. Doing so would result in a loss of revenue for the U.S. Treasury.

The Fed's increasingly activist role during the credit crisis has elicited recent criticism from ex-central bankers. Former Fed official Vincent Reinhart said Monday that the Fed's rescue of Bear will be remembered as the "worst policy mistake in a generation" at a panel organized by the American Enterprise Institute, a conservative-leaning think tank where he is now a scholar. Reinhart was director of monetary affairs at the Fed and secretary of its policy-making panel until 2007.

Reinhart's criticisms echoed those leveled recently by former Fed chairman Paul Volcker, who is credited for slaying inflation in the 1970s by cranking up interest rates despite howls of protest on Wall Street. Volcker comes from the opposite end of the political spectrum, having recently endorsed Sen. Barack Obama (D., Ill.) for president.

Volcker said at a recent speech at the Economic Club of New York that the central bank's recent actions raised political concerns about "the proper use and allocation of government power" and "embedded economic interests and lobbying."

He laid the blame for the credit bubble, which he called the "mother of all crises," on the explosion of the complex derivative securities market on Wall Street, which was championed by his successor at the Fed, Alan Greenspan.

"Simply stated, the bright new financial system, for all its talented participants, for all its rich rewards, has failed the test of the marketplace,'' Volcker said.

Some economists say the Fed will ultimately continue lowering interest rates beyond its April meeting as the slowdown in the U.S. economy deepens. On Wednesday morning, the government is expected to report that GDP grew at a pace of 0.5% in the first quarter. That would mark a slowdown from the 0.6% pace logged in the fourth quarter of 2007, but it would also suggest that the U.S. averted a recession in the first three months of 2008.

Many investors have concluded that a recession is already underway, and they point to continued declines in the U.S. housing market as a force that will drive the downturn. On Tuesday, Standard & Poor's reported that its Case-Shiller home price index of 20 cities fell by 12.7% in February versus last year, the largest decline since its inception in 2001. Seventeen of the 20 metro areas reported record annual declines.

Also, the Conference Board said that its Consumer Confidence Index, which declined sharply in March, fell again to 62.3 in April, down from the revised 65.9 last month and 76.4 in February. The consumer sentiment index, tracked by the University of Michigan, has also dropped to its lowest levels in over a quarter-century after the U.S. recorded three-straight months of declines in the job market.