With doubts surfacing anew about the sustainability of the economic recovery, an increasing number of Wall Street prognosticators say the Federal Reserve will be forced to cut interest rates again this year. The predictions, which have been coming out intermittently over the last several days, were behind part of Tuesday's 230-point Dow runup. The question investors must ponder, however, is whether the factors that led the market to even consider such a scenario will weigh more heavily than any potential cut will help. On Tuesday, Lehman Brothers economist Ethan Harris said he is placing 60% odds the Fed will reduce the funds rate, now at its lowest level in 40 years, in the next several months. His forecast follows Goldman Sachs' announcement Friday that it expects a 50- to 100-basis-point cut next quarter.
Reason to Believe
"A more than 20% plunge in the stock market since mid-May has eliminated about $3 trillion in market wealth," said Harris in a research note. "As Americans read their mutual fund statements and absorb the negative commentary in the news, consumer confidence and spending are increasingly at risk." In the last two weeks, several economic indicators have weakened, including existing home sales, durable goods orders, construction, consumer confidence, manufacturing surveys, and employment. Also, credit conditions continue to tighten, with commercial paper markets effectively closed to many companies. According to Harris, the Fed is likely to carry out a 25-basis-point cut in September, November, and December, pushing the Fed funds rate down to 1.0% -- which would be its lowest level since 1954. Harris added that he is not ruling out faster action, such as an inter-meeting move, or no action. Fed fund futures, a good proxy of policy, are putting 65% odds on a 25-basis-point cut in September.
Might Not Be Needed
"An easing is a distinct possibility, though I'm not ready to make a definitive call," said Mike Moran, an economist at Daiwa Securities. "If the economy isn't on track soon, the stimulus would be needed." Dresdner Kleinwort Wasserstein is forecasting a 25-basis-point easing at the Fed's November meeting. But Kevin Logan, a senior economist there, said it could happen as early as September. "A lot of it has to do with the stock market," said Logan. "We have had an enormous drop in a very short space of time. People are likely to respond to the loss by decreasing their spending and increasing their saving." Still, Wall Street experts are left to debate how low interest rates could eventually go. Tony Crescenzi, a bond market strategist at Miller Tabak and contributor to TheStreet.com's sister site RealMoney.com, thinks 1% interest rates are incredibly unlikely. A priority of the Fed is to keep real interest rates -- which subtract inflation -- in negative territory. Right now, inflation is at 2.3% and the fed-funds rate is at 1.75%, putting real rates at -0.55%. "The point is not to let inflation get too low, in order to avoid a Japan-like deflationary situation," said Crescenzi. "But I do not think that inflation is going to fall low enough to justify 1%."