Stock Mkt Plunge Spurs Debate On Early Rate Cut

NEW YORK (Dow Jones)–Unprecedented events in financial markets have left
economists uncertain whether a continued bloodbath in the stock market would
drive the Federal Reserve toward an emergency rate cut.

Some leading economists had already thought the Fed would opt for emergency
action after Friday’s dismal report on hiring in September. Those expectations
were renewed Monday amid a massive route in stock markets across the world.

That said, a consensus is hard to find. Some say there’s a chance the Fed would
act if the bottom continues to fall out of the stock market. Others say no - it’s
better to wait until the regularly scheduled policy meeting set for the end of
the month. But regardless of what camp forecasters belong to, few would offer
100% assurance that their view will prevail.

“All investors need to be on Fed watch,” said Cary Leahey, of forecasting firm
Decision Economics. “It’s not abundantly clear a rate cut will do that much,” but
even so, the Fed could opt for one, he said.

Arguments on both sides are plausible. There is precedent for monetary policy to
respond to extreme stock market distress. The 1987 Black Monday stock market
blowout was greeted by an emergency easing to restore confidence, in former Fed
Chairman Alan Greenspan’s first major test as central bank leader. The Fed also
cut rates after the reopening of markets following the Sept. 11 terrorist
attacks.

But on the other side of the ledger, the Fed has already cut rates considerably
since the crisis began, lowering the overnight target rate from 5.25% late last
summer to 2% now. They have held fire since the spring despite the ongoing litany
of market and economic woes.

Officials have found it more effective to tackle financial market distress with a
rapidly expanding portfolio of tools designed to provide liquidity to financial
markets.

Also, past rate cuts, market bailouts, new liquidity tools, they have all at best
thwarted even more dire events, and when they have lifted markets, the positive
impact has been temporary. With the funds rate already nearing rock bottom, the
Fed has precious little distance to cut rates further if more troubles arrive,
and it risks expending what little ammunition it has left.

“An inter-meeting move is certainly possible” given the current level of market
distress, said Jim O’Sullivan, economist with UBS. His bank already reckons a
half percentage point easing will happen at the end of the month, an expectation
shared by many major banks.

O’Sullivan offers a caveat. “For an inter-meeting move to be effective, it would
have to be part of coordinated move with other central banks.”

Talk of just such action helped the stock market back away from huge losses
Monday afternoon, losses that took the Dow Jones Industrial Average under 10,000
for the first time in four years. The UBS economist added that much like official
intervention on foreign exchange markets, there’s some reason to expect a rate
cut, solo or otherwise, would arrive at a time where the market has started to
find some footing.

Argus Research economist Richard Yamarone thinks a rate cut now would be a dumb
idea and a “sign of panic” that would do little for investor sentiment. It would
slam the dollar, the resilience of which is one of the U.S. economy’s few pluses
right now. But given all that’s happened over the last year, Yamarone said “I
wouldn’t be surprised” if the Fed cuts rates. “These are exceptional times” and
surprises are the order of the day, he said.

Pump It Up

With so little clarity over the timing and effectiveness of rate cuts, some
pointed out that the Fed’s new ability to pay interest on required reserve
deposits will make even the current stance of rate policy more effective.

Implemented Monday following last week’s approval of the financial rescue bill,
the Fed will now pay banks the average targeted funds rate set by the Federal
Open Market Committee, minus 10 basis points. The Fed believes this action
“should essentially eliminate” the value of holding onto bank reserves and make
this key source of market liquidity more efficient.

Miller Tabak strategist Tony Crescenzi noted this ability allows the Fed to
massively expand some of its other liquidity providing tools. He viewed the
latest round of initiatives as something that will effectively allow the Fed to
fire up the printing press and further boost market liquidity.

Monday, the Fed already took a first step in that direction, substantially
increasing the size of its cash offerings to deposit-taking banks so that, the
central bank said, “$900 billion of (Term Auction Facility) credit will
potentially be outstanding over year-end.”

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