Fed to slash rates as recession looms

Fed Chairman Ben Bernanke and his colleagues, who gather on Tuesday and Wednesday, have already cut the benchmark federal funds rate to 1.5 per cent from 5.25 per cent over the past 13 months. They will announce their latest decision around 2:15 p.m. EDT (1815 GMT) on Wednesday.

The Fed held rates steady at its last policy meeting on September 16, but cut rates by a half-point on October 8 in an emergency move coordinated with other major central banks.

The sharp rate cut was complemented by other recent steps to create new funding facilities or expand existing ones to try to ease strains in credit markets that had become increasingly paralyzed by risk aversion, especially after investment bank Lehman Brothers failed in September.

The coordinated efforts have helped ease the global credit crunch, but baby steps on short-term money markets have been overwhelmed by bigger problems for the overall economy.

“The stabilization of the financial system, though an essential first step, will not quickly eliminate the challenges still faced by the broader economy,” Bernanke acknowledged in congressional testimony last Monday.

WHEN DOVES CRY

A Reuters poll on October 16 showed economists predicting the US economy would contract for three straight quarters, beginning with the third quarter that ended last month. Such a streak of declining gross domestic product would be the longest since 1974-75.

The US Commerce Department will release its first snapshot of third-quarter GDP on Thursday, the day after the Fed announces its decision.

The US labor market has shed jobs for nine consecutive months with no end in sight, while industrial output nosedived in September and consumer confidence has cratered, taking retail demand down.

The Institute for Supply Management’s index of factory activity fell in September to 43.5, far into territory associated with recession, and regional indexes have suggested manufacturing activity has fallen further this month.

While retail sales dropped by 1.2 per cent in September, a dramatic plunge in gasoline prices might salvage consumer spending in the final weeks of 2008 — which would offer a rare bright spot for an economy the appears on a downward slope.

Gas prices have already been tracking the sharp drop in the price of crude oil, which has fallen by more than half since a record peak at $147 in July.

“If gasoline prices continue to move lower, they will start to act like an economic tail wind, which is clearly a positive development,” said economists at Deutsche Bank.

GLOOM GROWS, INFLATION SLIPS

The spreading gloom has been reflected in remarks from Fed officials that hint at a willingness to lower rates further to try to stem the economy’s slide.

San Francisco Federal Reserve Bank President Janet Yellen said on October 14 that the nation “appears to be in recession,” while Chicago Fed President Charles Evans three days later said that the spike in the jobless rate to 6.1 per cent from a low of 4.4 per cent in March 2007 basically makes recession inevitable.

With the Fed’s interest-rate ammunition already running low, Bernanke went before Congress last week and endorsed the idea of a second fiscal stimulus plan to complement the central bank’s efforts to rescue the economy.

“With the economy likely to be weak for several quarters, and with the risk of a protracted slowdown, consideration of a fiscal package by the Congress at this juncture seems appropriate,” Bernanke said.

INFLATION OUTLOOK FLIPPED

The Fed had astounded some analysts in September by expressing equal worries about growth and inflation, even though energy and other commodities prices were already two months off their peaks and falling rapidly.

Since then the pendulum has swung further toward disinflation, so September’s assessment that “downside risks to growth and the upside risks to inflation are both of significant concern” will certainly be reworked.

Ten-year inflation expectations reflected in securities prices are now below 1 per cent, or under the low end of a range that many policy-makers see as “price stability.”

“Officials may yet confront a potentially pernicious deflation, entailing faltering demand, falling nominal incomes and strangling real debt burdens,” Citigroup’s DiClemente warned.