Fed May Cut to 5 Percent Without Promising More: John M. Berry

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Sept. 7 (Bloomberg) -- If Federal Reserve officials cut their 5.25 percent target for the overnight lending rate when they meet on Sept. 18, it will be by only a quarter-percentage point with no promise of more to come.

Officials have already disappointed many market participants by refusing to cut the target in response to turmoil in financial markets. And they will surely disappoint those hoping for a half-point cut at the next meeting of the Federal Open Market Committee.

While the Fed might decide on a rate reduction as a bit of insurance against having growth weaken too much, there's no sign of serious problems in the economy outside of housing.

New information can still influence the meeting's outcome because the impact of the financial market dislocations on the economy remains so uncertain. But right now there's no worry among Fed officials that the economy is about to fall out of bed, or that some major financial institution is going belly up.

As Fed Chairman Ben S. Bernanke said in his Aug. 31 speech at the Kansas City Federal Reserve Bank's conference in Jackson Hole, Wyoming, ``The incoming data indicate that the economy continued to expand at a moderate pace into the summer, despite the sharp correction in the housing sector.''

Bernanke acknowledged that, given the sudden loss of liquidity in financial markets, including the squeeze hurting commercial paper, data for past months or quarters ``may be less useful than usual for our forecasts of economic activity and inflation.''

Healthy Economy

There's no doubt that this particular crisis has hit against a background of generally healthy economic activity -- again, except for housing -- and at a time when most financial institutions are well capitalized and highly profitable.

In this unusual period, Bernanke also said policy makers ``will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country.''

A summary of that gleaning, through Aug. 27, was published on Sept. 5, in the Fed's Beige Book, which is always released two weeks prior to an FOMC meeting.

All 12 of the district Federal Reserve banks, which gather the information, reported that the economy was still expanding, albeit at a slower pace in four of the districts. Consumer spending generally was increasing, while manufacturing production picked up in most areas. In addition, employment was also still rising.

Limited Turmoil

In contrast, housing continued to weaken with lenders tightening standards. Commercial real estate borrowers also were facing somewhat tighter lending standards, while ``credit availability and credit quality remained good for most consumer and business borrowers,'' the summary said.

``Outside of real estate, reports that the turmoil in financial markets had affected economic activity during the survey period were limited,'' it added.

None of that suggests there is any emergency that requires an immediate Fed response.

So what the FOMC does on Sept. 18 probably comes down to a matter of risk management. If the data and the anecdotes continue to depict a pretty healthy economy, the unusual degree of uncertainty about the outlook might lead officials to decide the best decision is a 25 basis point cut just in case the impact of the financial turmoil turns out to be greater than they expect.

Inflation Concern Eases

Officials haven't dropped all concern about inflation, though at the moment it seems clear that potential economic weakness is the greater risk. The FOMC statement issued on Aug. 17 made that clear.

The good news is that core inflation has receded enough that it gives the committee more freedom to respond to any growth threat than it otherwise would have.

For instance, the core consumer price index, which excludes food and energy items, rose 2.2 percent in the 12 months ended in July. The core personal consumption expenditure price index, the Fed's preferred measure, was up only 1.9 percent over the same period.

The latter was just inside the 1 percent to 2 percent range some Fed officials, including Bernanke, say they would like to keep it within.

So long as core inflation and inflation expectations remain in bounds, officials will respond with more aggressive actions if problems in housing or more broadly in financial markets appear likely to drag down the entire economy.

Plenty of Art

As Fed Governor Frederic S. Mishkin outlined in a paper he presented at the Jackson Hole conference, a central bank may not be able to identify or do much about an asset price bubble. It can and should, however, take aggressive, proactive steps to mitigate any damage the bursting of such a bubble can cause.

Exactly what those steps should be is hard to determine in advance, Mishkin said, because so little is known about how housing affects the larger economy, and about how monetary policy affects housing.

``The uncertainty around housing-related monetary transmission mechanisms provides one further reason why monetary policy will continue to be an art, albeit one that makes use of science,'' he said.

Look for plenty of art from the Fed before this year is out