Debate about the size of an interest-rate cut might miss the point: The statement could mean more.
June 24, 2003: 1:16 PM EDT
By Mark Gongloff, CNN/Money Staff Writer
NEW YORK (CNN/Money) - Though Wall Street has been roiled by a debate about the size of the Federal Reserve interest-rate cut almost certain to come Wednesday, the debaters may be missing the point: What the Fed says could be more important than what it does.
Fed policy makers begin a two-day meeting Tuesday to discuss the state of the economy and their target for short-term interest rates. Fed officials have built up market expectations for a rate cut for weeks, so almost no economists expect the central bank to throw investors a curve and not cut rates.
The only question, then, is the size of the cut. According to a recent Reuters poll, a slim majority of the 21 banks that do business directly with the Fed expect the central bankers to cut their target for the federal funds rate, an overnight bank lending rate, by half a percentage point, to 0.75 percent, a level not seen consistently since 1958.
But a half-percentage-point cut is far from a sure thing. A Wall Street Journal article last week -- possibly the result of leaks by the Fed calculated to lower market expectations, some economists believe -- said the Fed was worried about the repercussions of taking the fed funds rate so low.
If such caution wins the day, then a quarter-percentage-point cut will result. (For more on the debate over the size of a Fed cut, click here).
But in either case, the Fed cannot avoid the daunting task of managing investors' expectations about the future of interest rates. Mostly, it will need to convince the markets it's not going to raise rates anytime soon. But it can't directly say that, since it needs to keep open the option of jacking up rates if economic growth suddenly explodes.
"It's a psychological game," said Citigroup economist Steven Wieting. "Any time there's any sign of economic recovery, the next question [for the markets] is when the Fed will choke it off. And markets shouldn't be thinking that way."
It's also critical for the Fed to make the distinction, as it did in its policy statement in May, between inflation and economic growth. In May, the Fed said that, even though the economy was still growing, it might not be growing quite fast enough to fuel inflation.
The fear is that disinflation -- or falling inflation, which sounds like a great thing -- could eventually turn into deflation, which is a very bad thing. When there's deflation, companies can't raise prices to keep up with wage growth, so they cut workers, which hurts the economy, and that makes prices fall even further.
"There is a risk of unwanted further disinflation," Wieting said. "The forecasts for 2004 are optimistic on GDP, but inflation will fall further."
The Fed pushes interest rates up when it wants to slow the economy down and fight inflation, and cuts short-term rates when it wants to lower borrowing costs and get the economy moving faster.
In response to a recession, terror attacks, corporate scandals, war and other woes, the Fed has cut the fed funds rate 12 times since the start of 2001, to a 41-year low of 1.25 percent.
Other, longer-term rates have also tumbled to historic lows. Most importantly, mortgage rates are lower than ever, encouraging a boom in housing that's helped homeowners feel wealthier and allowed people to refinance mortgages at lower and lower rates, putting more cash in their pockets.
Though economic growth in 2002 and 2003 has been too sluggish to fix the weak labor market, most economists, including Fed Chairman Alan Greenspan, believe the economy will be stronger in the second half of this year.
Nevertheless, the Fed's most recent "beige book" study, which compiles reports of economic conditions around the country and is used in policy-making decisions, found an economy still in need of a boost, or at least a little insurance to help ward off possible deflation.
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