Fed Officials May Split the Difference on Cut

In September, Fed officials were aggressive in cutting rates. In October, they were gradual.

Now, faced with a slowing though still-expanding economy that might only require modest rate reductions and renewed strains in financial markets that argue for much deeper cuts, they may split the difference.

Call it aggressively gradual.

The Fed is widely expected to lower the federal-funds target rate by 25 basis points, as it did in late October, to 4.25% when it meets today. A government report Friday showing payrolls up 94,000 in November, along with other data on manufacturing and services activity, have eased concerns of an imminent recession, making a half-percentage-point cut less likely than it was a few days ago.

But the Fed is expected to cut the discount rate — the rate it charges banks that borrow directly from the Fed — by 50 basis points, as it did in September, to 4.5%, economists said. That would lower the so-called penalty rate — the spread between fed funds and discount rates — to just 25 basis points and encourage banks to make more widespread use of that facility.

Credit market conditions have eroded in the past month based on measures such as the London interbank offered rate, or Libor, and wider spreads between three-month Treasury bills and three-month Eurodollars — known as the TED spread. Asset-backed commercial paper outstanding has fallen recently, another sign of stress in the system, and the housing correction has shown no sign of letting up even though there is still scant evidence of any spillovers.

"I think the Fed wants to send a signal that it takes turmoil in markets seriously," a former Fed Governor now with the Stanford Group, Lyle Gramley, said. "One way to do this is to lower the penalty rate."

The Fed wasn't expected to be in this position a few weeks ago.

In fact, it had sent multiple signals that the October 31 rate cut would be the last for a while. In a statement accompanying that decision, officials said inflation and growth risks were roughly balanced. It also made reference to the cumulative 75 basis points in fed-funds reductions since September, which many Fed watchers took as a hint that the Fed thought its work was done.

And throughout much of October a number of officials — including Fed governors Frederic Mishkin and Randall Kroszner, as well as the president of Philadelphia Fed, Charles Plosser, and others — sent strong signals that they thought the rate stance was appropriate.

Yet Wall Street never wavered from its view that the Fed would have to lower rates again to shore up credit markets and address the housing slump. And around two weeks ago the Fed seemed to blink, with the vice chairman of the Fed, Donald Kohn, and then the chairman, Ben Bernanke, highlighting the economy's vulnerabilities, which Wall Street took as a clear sign of more rate cuts.

"Looking back, I think the October 31 release (and its balanced risk assessment) was a mistake," Mr. Gramley said.

But the Fed may shy away from explicitly saying that downside growth risks outweigh inflation risks.

Officials could instead recycle language they used when they cut rates in September. "Developments in financial markets since the Committee's last regular meeting have increased the uncertainty surrounding the economic outlook," the Fed said then, opting not to issue a balance-of-risks assessment at all.