Fed Skeptical of Recession, Cut Disappoints Investors (Update1)

By Scott Lanman and Craig Torres

Dec. 12 (Bloomberg) -- Federal Reserve officials still expect the economy to grow and are reluctant to deliver the deeper interest-rate reductions demanded by some economists and investors.
The Federal Open Market Committee lowered the benchmark rate by a quarter-point yesterday to 4.25 percent, and said cumulative cuts of 1 percentage point this year should promote ``moderate growth.'' Policy makers also dropped their assessment that growth and inflation risks were ``roughly'' equal and cited ``uncertainty'' about the outlook.
The move put the central bank, which has struggled to contain the subprime credit collapse, further at odds with investors. The Dow Jones Industrial Average fell the most after a Fed decision since Ben S. Bernanke, 53, became chairman in February 2006 as traders speculated he will fail to avert a recession. Officials haven't ruled out further steps to ease the credit squeeze in financial markets before they meet Jan. 29-30.
``This is a reluctant committee, they didn't want to ease,'' said Vincent Reinhart, former director of the Fed's Division of Monetary Affairs and now a resident scholar at the American Enterprise Institute in Washington. ``The data are coming about as expected, and they are being asked to respond. They view that as double-counting.''
Officials are actively considering ways to stem a surge in borrowing costs among banks and increase liquidity in markets. Some economists were disappointed the Fed didn't announce a greater cut to the discount rate than the quarter-point that officials delivered yesterday.
Yields Tumble
Stocks fell in Europe and Asia after the Fed's decision. Treasuries also fell, with two-year yields rising 12 basis points, or 0.12 percentage point, to 3.04 percent by 9:37 a.m. in London, according to bond broker Cantor Fitzgerald LP.
Futures prices showed traders anticipate the Fed will cut its main rate to 3.75 percent or lower by the end of March. A basis point is 0.01 percentage point.
``I can't remember a time when the Fed's credibility with the markets has been lower than it is today,'' said Stephen Stanley, chief economist at RBS Greenwich Capital in Greenwich, Connecticut, and a former Fed researcher. ``Practically everyone has something to be disappointed with'' in the Fed's statement.
The Fed lowered the charge on direct loans to banks, the discount rate, to 4.75 percent, surprising economists who expected a half-point reduction to encourage more borrowing.
Direct Loans
Fed Vice Chairman Donald Kohn and other officials have expressed frustration banks haven't made more use of direct loans. While lending jumped as high as $7.2 billion on Sept. 12, it has since retreated.
Concern about mounting losses on securities linked to mortgages diminished banks' willingness to lend to each other, sending funding costs higher. The three-month dollar London Interbank Offered Rate rose to 5.11 percent yesterday from 4.87 percent a month before.
``Strains in financial markets have increased in recent weeks,'' policy makers recognized yesterday. That contributed to the ``uncertainty surrounding the outlook for economic growth and inflation,'' the Fed said.
The risk of companies defaulting on their debt rose the most in a month yesterday. The Markit CDX North America Investment Grade Index, a U.S. benchmark, climbed 6 basis points to 79 basis points, according to Deutsche Bank AG in New York.
Economists said the central bank may consider steps such as extending discount-rate loan terms to 90 days, from 30. In 1999, the Fed addressed potential money shortages during the 2000 computer-system changeover by selling options on almost $500 billion of repurchase agreements.
Dissenting Vote
Policy makers weren't united on yesterday's decision. Boston Fed President Eric Rosengren, 50, a former bank- supervision chief with a research background in New England and Japanese financial crises, favored a half-point reduction.
Only seven of the 12 Fed district banks requested the quarter-point discount-rate cut, suggesting some asked for a bigger move, analysts said.
The Fed has avoided stating that growth was a bigger concern than inflation in its statements since August. On Aug. 7, the FOMC said inflation was a greater risk, only to cut rates the next month. Officials said after their Oct. 30-31 meeting that the risks were ``roughly'' equal.
Each time, futures trading showed traders shrugged off the comments, continuing to bet on further rate cuts.
`Self-Fulfilling'
``The Fed's tendency to be more reactionary, combined with a market braced for a greater, more pronounced slowdown, amounts to a self-fulfilling prophecy,'' said Taylor Burroughs, an Atlanta-based derivatives analyst at Regions Financial Corp., with $138 billion in assets. ``The Fed is looking at forecasts and the market is more focused on the here and now.''
Officials noted that ``elevated energy and commodity prices'' may cause faster inflation. A Labor Department report Dec. 14 may show consumer prices climbed 4.1 percent last month from a year before, according to the median forecast in a Bloomberg survey. Excluding food and energy, prices probably rose 2.3 percent, from 2.2 percent in October.
Policy makers may feel as if they're ``walking in a dark room,'' said Bruce Kasman, chief economist at JPMorgan Chase & Co. in New York. ``They're not feeling as certain as they would like to about where the economy is heading.''
To contact the reporters on this story: Scott Lanman in Washington at slanman@bloomberg.net ; Craig Torres in Washington at ctorres3@bloomberg.net Last Updated: December 12, 2007 05:47 EST