FOMC Preview: All Eyes on the Fed

by: SA Eli Hoffmann

It is widely expected that the Federal Reserve will shave its benchmark fed-funds lending rate at its FOMC policy meeting Tuesday, although economists disagree by how much. In his statement, Chairman Ben Bernanke will likely tread cautiously, justifying the cut without spooking investors that the economy may be moving toward recession. Most economists forecast a quarter-point cut to 5%. Such a move, though, might be seen as inadequate given the unforeseen swiftness of the current credit and mortgage market crisis. A significant minority, including Goldman Sachs and Merrill Lynch, foresee a half point cut to 4.75%. However, such a drastic move could unintentionally rekindle inflationary concerns, and may be perceived as a bailout of risk-happy investors who now find themselves in a liquidity crisis. Policy makers "are really caught," Robert Eisenbeis, a former research director at the Atlanta Fed said. "The Fed needs to avoid the perception of bailing out the markets, lenders or borrowers." The statement accompanying today's decision will be dissected by analysts and economists worldwide, who will look for language that downplays inflation, addresses the current liquidity turmoil, or gives any hint to further rate cuts.

While all eyes are focused on the fed-funds rate, the Fed will also decide whether to cut its 'discount window' rate. Banks lend to each other using the federal-funds target rate. As a last resort, they can borrow from the Fed itself, using the discount window, but paying an interest rate penalty. On Aug. 17, in hopes of improving cash-flow to illiquid credit markets, the Fed cut the discount rate from 6.25% to 5.75%, a half a percentage point above the 5.25% federal-funds target. It also extended its loans to as long as 30 days, from just one day, in the hope banks would use discount window loans to return liquidity to cash-strapped markets. The actual penalty of borrowing from the window, though, is more than the implied half point, because the Fed has at times allowed the fedfunds rate to fall below its target to 5%. Some analysts say the Fed will have to cut the discount rate to just a quarter point above the fed-funds rate, or even match it, before banks will use the window in earnest. One idea making the rounds is that the Fed will cut the fed-funds rate by a quarter point to 5% and the discount rate by a half point to 5.25%.

The rate-setting FOMC meeting begins at about 8:30 a.m. A statement outlining the committee's decision is due at about 2:15 p.m.

Sources: Bloomberg, Wall Street Journal, MarketWatch, Reuters
Commentary: All Eyes On the FedThe FOMC Will Cut 25 Basis Points - Not 50What Will the Anticipated Rate Cut Really Change?
Stocks/ETFs to watch: SPY, DIA, AGG

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