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Fed to Cut Rates at Next FOMC Meeting as U.S. Recession Appears Likely

By , Money Morning •

By Jason Simpkins
Associate Editor
Money Morning

The U.S. Federal Reserve is likely to cut rates tomorrow (Wednesday), possibly in conjunction with central bank counterparts in Europe, as fears of a global recession have intensified. However, the Fed has little room to maneuver as its benchmark Federal Funds rate is already at 1.5% and analysts remain skeptical that reducing it any further keep the United States from sliding into a prolonged recession.

The next meeting of the Federal Open Market Committee is scheduled for tomorrow Wednesday Oct. 29. There is no doubt that growth will be the central issue of the committee’s discussion, as fears of a global recession are intensifying alongside deteriorating economic data.

The British Office for National Statistics’ said Friday that, after a flat second quarter, U.K. gross domestic product (GDP) contracted 0.5% in the three months ended Sept. 30. There’s little doubt that other European nations have already succumbed to recession, and the near bankruptcy of Iceland has highlighted the interdependency of the world’s financial system.

It’s likely that Germany, France and Italy have already entered into a recession, as their second-quarter GDP fell 0.5%, 0.3% and 0.3%, respectively. Japan – the world’s second largest economy – is also dangerously close to recession, with its economy having contracted 2.4% in the three months ended June 30.

The International Monetary Fund (IMF) said last week that the economy of the 15-country Eurozone would grind to a virtual standstill in 2009. And the prognostications for the United States are equally bad, if not worse.

The U.S. economy expanded by 2.8% in the second quarter, but that expansion was largely the product of government stimulus checks and a weak dollar. The federal government returned roughly $168 billion back to American taxpayers in the form of rebate checks earlier this year.  The tax rebates, which were mailed through May, kept U.S. consumers afloat, while a weak dollar accelerated a torrent of exports out of the country.

Since then, consumer spending has been undermined by rising unemployment and the dollar has strengthened substantially.

The unemployment rate hit a five-year high of 6.1% in September and jobless claims have continued to mount this month, with a seasonally adjusted 478,000 Americans filing for first-time unemployment benefits in the week ended Oct. 18. Initial jobless claims have soared 47% in the past year and continuing claims are up 44%.

Meanwhile the greenback has posted a strong rebound over the past month, making U.S. goods more expensive to foreign nations, and thereby weakening exports.

The dollar climbed 5.9% against the euro last week and yesterday (Monday) surged to a two year high of $1.2462 versus the European currency.

The economy has nothing left to lean on at this point, and that fact has most economists projecting a debilitating recession for the United States.

“We are now expecting one of the sharpest recessions in the post-war period,” Citigroup Inc. (C) analysts Geoffrey Dennis and Jason Press wrote in a report to clients on Oct. 21. Citi sees an entire year of contraction before the economy gets back on track in the second half of 2009. Dennis and Press predict U.S. unemployment could climb as high as 8.5% next year.

“The growing reality is that this is not just a slowdown, but a true recession,” Joel Naroff, president and chief economist of Naroff Economic Advisors said in an interview with Money Morning.

“U.S. GDP contracted significantly in the third quarter,” said Naroff, who believes GDP may have contracted as much as 2.5% - 3.0% in the quarter. “Such a sharp slowdown is not expected.” 

So far, Federal Reserve Chairman Ben S. Bernanke has turned to his ever-expanding arsenal of liquidity measures in an attempt to thwart what now seems to be an unavoidable recession. However, he may eventually be forced to cut interest rates all the way to zero like the Bank of Japan did in 1999.

But first the Fed will reduce its benchmark Federal Funds target rate tomorrow by 25-50 basis points.

"The cut is already in the market," John Ryding, economist at RDQ Economics told AFP.
“The question is whether it's 25 or 50 basis points."

The latter would mean reducing the key rate from where it currently stands at 1.5% to just 1%. Cutting below 1% could be seen as a sign of panic, according to some analysts.

Earlier this month, the Fed conducted a joint rate cut with a number of its global partners, and other central banks around the world could again join the United States in reducing rates.

The European Central Bank (ECB) could cut its rates as soon as next week at the next meeting of the central bank’s Governing Council scheduled for Nov. 6. 

“I consider it possible that the Governing Council would decrease interest rates once again at its next meeting,” ECB President Jean-Claude Trichet said yesterday. “Taking into account the recent substantial decline in commodity prices together with a substantial weakening in demand which has emerged lately, upside risks to price stability have diminished.”

Nick Parsons, head of markets strategy at nabCapital (OTC: NABZY) in London, told The Guardian, that the Bank of England (BOE) could also follow the Fed’s move with a one-point cut of its own. That would leave the BOE’s rate at 4.5%

The ECB, which raised rates as recently as July, cut its benchmark by half a point on Oct. 8 to 3.75%. 

The Fed’s Broadening Balance Sheet

Cutting rates would certainly fit into Chairman Bernanke’s tactic of flooding the market with liquidity – a tactic that began last August and has broadened over the past year to include more and more tools at the Fed’s disposal. As a result, the role of the U.S. Federal Reserve as an institution has completely changed.

After previous rate cuts and cash injections failed to unfreeze credit markets, Bernanke got the green light to start buying up troubled assets and taking equity stakes in financial institutions.

Up until a year ago, the vast majority of the Federal Reserve’s holdings were in Treasury securities. However, over the past several months, Bernanke has expanded the role of the Fed to include the programs ranging from the Fannie Mae (FNM) and Freddie Mac (FRE) bailout, to becoming a buyer of last resort for undesirable assets.

In fact, the Fed set the interest rates it will charge for its purchases of commercial paper from banks and companies. The Fed said it would charge 1.88% for unsecured commercial paper and 3.88% for asset-backed commercial paper, Reuters reported.

The Fed created its program to buy 90-day commercial paper directly from issuers three weeks ago, on Oct. 7.

“The net effect of these facilities has been a truly staggering pace of growth in the Fed's balance sheet,” said Jan Hatzius, chief U.S. economist for Goldman Sachs Group Inc. (GS).

The Federal Reserves balance sheet has more than doubled as a result, and it’s showing no signs of abating. As of Oct. 15, the Fed’s balance sheet had ballooned to $1.754 trillion from around $850 billion last year, according to The Wall Street Journal.

“In coming months, further rapid growth in the Fed’s balance sheet is likely,” said Hatzius. Hatzius also pointed out that during the Japanese credit crisis of the 1990s, the Bank of Japan’s balance sheet hit 30% of GDP, compared to the United States where the Fed’s balance sheet is currently at about 12% of GDP.

“To be sure, part of this increase occurred in an environment of outright quantitative easing by the Bank of Japan, which is not our current forecast for the Federal Reserve,” he said. “Nevertheless, the Japanese experience illustrates that central balance sheets can grow to very large numbers when the monetary authority is called upon to take over short-term financing for a large part of the economy.”

Japan suffered a decade of stagnation in the 1990s after its property and stock market bubbles burst. Money Morning Executive Editor Bill Patalon has written extensively about the eerie similarities between that collapse and the potential lost decade that could be faced in the United States.

The H.4.1 report – the Federal Reserve's weekly report on changes to its balance sheet, set for release Thursday – will reveal how much capital was withdrawn from the Fed’s new commercial paper facility in the first three days of this week.

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