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The Fed Can't Afford Not to Cut

Having raised expectations -- along with deflation fears -- the Fed has to cut or cause consternation in the market.


Federal Reserve

is widely expected to lower interest rates Wednesday, but not necessarily because of economic reasons. In one of the strangest developments in central bank history, the Fed is very likely to ease mainly because they said they would.

The main debate about the outcome is whether the Fed's rate-setting body eases by 25 or 50 basis points. Arguments can be made for either choice or even for no rate cut, as discussed below. But the twist is that the most compelling reason for the Fed to act is because it has generated such high expectations for another rate cut.

"The Fed painted itself into a corner," said Marc Chandler, chief currency strategist at HSBC USA and a contributor to


. "We could get by with no cut except for expectations

that have been raised by the Greenspan Fed. The chaos of doing nothing could be greater than the instability of a 50-basis-point cut."

Chaos is perhaps too strong, but there very likely will be some drama if the Fed defies expectations and stands pat. Late Tuesday, fed fund futures were pricing in 100% odds of a 25-basis-point rate cut and 52% odds of an additional quarter-point ease. Economists at all 22 of the Fed's primary bond dealers forecast a rate cut of some magnitude, as did every source queried for this story (even if the "because we said we would" rationale behind it is troubling).

Such certainty stems from a belief there's been a "regime change" at the Fed, whereby the central bank is now more concerned about deflation, or at least disinflation, than its historic enemy, inflation. Culminating a series of similarly themed statements by various Fed officials, the Federal Open Market Committee's

May 6 policy statement declared: "The probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation." (Fed Chairman Alan Greenspan repeated that phrase, almost verbatim, during

congressional testimony on May 21.)

Phantom Menace?

The Fed's main rationale for easing again seems to be to take out additional insurance against future deflation, a self-replicating cycle of falling prices leading to diminished economic activity. But as when many argued the Fed was backward-looking in tackling inflation in 1999-2000, some fear the central bank is once again fighting the last battle.

HSBC's Chandler does not believe deflation is a threat, citing factors such as narrowing credit spreads for corporate bonds, expectations in Treasury Inflation Protected Securities for 1.7% annual inflation for the next decade, rapid growth of money supply, strength in the U.S. banking system and the roughly 20% decline in the dollar vs. a basket of major currencies in the past two years.

"None of those things point to deflation,

but to the opposite," he said.

Nor are there deflationary warnings in other indicators: recent strength in equities, active lending activity -- especially related to housing -- and recent improvements in the index of leading economic indicators, retail sales and consumer confidence. (The Conference Board said June consumer confidence dipped to 83.5 from 83.6 in May, but the expectations component is up 56% since March.)

But "with the Fed's attention firmly fixed on the small but important risks of deflation, the 'real' economic releases may matter less than usual," economists Peter Kretzmer and Mickey Levy of Banc of America Securities observed. "While the chances of economic improvement have risen since the last meeting, signs of a pickup are at best tentative, requiring more time to corroborate."

Given that, the economists believe the Fed will ease by 25 basis points and signal the possibility of more easing going forward. HSBC's Chandler expects the same, although the firm's "official" forecast from economist Ian Morris is for 50 basis points. (Morris did not return calls seeking additional comment.)

The Scenarios, Please

Although a 25-basis-point ease is most likely, there's plenty of fodder for alternative outcomes with varied market reactions.

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As expected:

A 25-basis-point ease will "prolong the rally mood," according to Brett Gallagher, who oversees $600 million as head of U.S. equities for Julius Baer Investment Management. A quarter-point cut signals the Fed is "still on the job, but not panicked into doing anything drastic," he said.

Given the stock market's struggles in the past week, a "Fed-inspired" rally seems reasonable, assuming the FOMC announcement doesn't bring any surprises. Indeed, whatever action the Fed takes, its risk-assessment statement will have huge implications for financial markets.

The Big Easy:

A 50-basis-point ease wouldn't be shocking, but it would surprise the majority.

Like many, Gallagher fears a more aggressive easing "smells of panic," and the financial markets would react accordingly. Diane Garnick, chief strategist at Dresdner Kleinwort Wasserstein, agreed, suggesting "if it is 50, it could mean the Fed is looking at some pretty horrific data."

Furthermore, Gallagher and Chandler (among others) worry about the unintended consequences of a 50-basis-point ease, most notably on the money market industry. A half-point ease would bring the fed funds rate to 0.75%, right around the average annual expense charged by money market funds. Money market fund participants are among the biggest buyers of commercial paper, Chandler noted, so anything that disturbs money markets could have negative "knock-on effects" for that crucial financing tool of corporate America.

Then again, what if the Fed cuts 50 and issues a statement signaling it believes its historic rate-cutting cycle is over? "I really think the equity market would love to see a 50-basis-point cut and indication from membership suggesting the deflationary threat is over," which would be consistent with a restoration of pricing power and improving corporate earnings, said William Sullivan, senior economist at Morgan Stanley. "I doubt that scenario

will occur, but equities would love an additional boatload of liquidity and a "the-worst-is-behind-us" statement.

Sullivan is probably right about the near-term reaction. However, Garnick suggested the Fed "may have lost some credibility in terms of assuring us this is the last move" after lowering the fed funds rate 12 times since January 2001. That's a salient point, and raises the question of why so many market participants are seemingly betting the 13th rate cut will be the charm.

No rate cut for you:

On the surface, no action by the Fed would be a "worst-case scenario" for equities and short-term Treasuries, as Morgan's Sullivan suggested. Certainly, no rate cut would be a surprise to financial market participants, who generally don't like surprises.

But "if they came out with no reduction, I think the stock market would take that as a statement the economy is OK," Gallagher said. "That would lend some support to the bulls, and allow the market to run further."

Probably so. The problem with the no-rate-cut scenario is it very likely would send long-term Treasury prices plummeting, with yields ratcheting higher. "I don't think

the Fed needs to do much here except keep the long-end

yields down," said Jeffrey Kleintop, chief investment strategist at PNC Advisors, a Philadelphia-based firm with more than $48 billion under management. "If they do nothing, the long end would back up and stocks would falter, because without strength in housing, consumer spending might falter."

Consciously or not, Kleintop hit upon the very thin tightrope on which the Fed finds itself. On the one hand, it wants to convey confidence about the economy's path, to keep equities and corporate bonds afloat. On the other hand, it doesn't want to overstate the economy's strength and unnerve the Treasury market, to which the crucial housing sector is inexorably linked. On the third hand, talking up the economy too much might prompt undue strength in the dollar, which could hamper any recovery by U.S. exporters. Finally, the Fed needs to acknowledge the deflationary risks without seeming panicked over them.

With all those hands (and balls) in the air, my expectation is the Fed will opt for a less-aggressive (but still vigilant) 25-basis-point ease.

Aaron L. Task writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.