Investors Focused on Size of Fed Rate Cut, Outlook

Includes: DIA, IEF, SPY
by: SA Eli Hoffmann

The Federal reserve is widely expected to cut interest rates Tuesday at its FOMC policy meeting, despite having set the stage for keeping its fed funds target steady after dropping the rate at its previous meeting on Oct. 31 (full story). "They pretty much tried to draw a line in the sand by going to a balanced-risks statement at the last meeting, and now the world's changed," economist Keith Hembre, who used to work at the Fed, said.

Late last month, Fed Vice Chairman Donald Kohn, and subsequently Chairman Ben Bernanke, surprised investors when they remarked that economic turbulence over recent weeks has largely undone any previous improvements in market function. "Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses," Kohn said. The statement, which was followed by almost identical remarks from Bernanke, came in stark contrast to those of other Fed officials, who had until then indicated they were generally satisfied with present interest-rate levels in view of the present economic outlook (full story I, II).

A full 115 out of 124 economists surveyed by Bloomberg now anticipate a 0.25% cut to 4.25%. Seven foresee a half-point cut, and two think the Fed will keep rates steady. Traders were more bold. A 0.25% cut is fully discounted according to futures contracts on the CBOT, while the odds of a half-point reduction are 28%.

Also in focus will be any adjustment to the Fed's Oct. 31 outlook that, "after this action, the upside risks to inflation roughly balance the downside risks to growth." Last week, the central banks of England and Canada dropped lending rates, highlighting concerns about financial market turmoil (full story). "Inflation risks are present, but it is very hard to argue they are on par with growth risks," said economist Brian Sack. "We'll see a more flexible message, more attuned to the downside growth risks."

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