Investors ask not if, but when Fed will cut rates

“This is a day to day proposition. The credit markets are still walking on egg shells. Almost every day we get another bad announcement,” said David Jones, head of DMJ Advisors, a Colorado-based consulting firm.

The current market volatility represents the first big test for Fed Chairman Ben Bernanke, who took over in February 2006 when Greenspan stepped down after 18½ years at the helm of the Fed.

The scholarly Bernanke, who came to the Fed after spending most of his career teaching monetary policy at Princeton University, is being watched closely to see whether he has the street smarts that Greenspan exhibited in knowing how to read and communicate with financial markets.

Part of the challenge is that Bernanke’s Fed has been insisting that its biggest worry is not the slowdown in the economy that has been occurring because of the worst slide in housing in 16 years, but the threat that inflation pressures will not ease.

Even last week, the Fed said after its Aug. 7 meeting when it left interest rates unchanged that its “predominant policy concern” remained the risk that inflation would not moderate as expected.

The Fed did get good news on inflation this week with the Labor Department reporting Wednesday that consumer inflation edged up a tiny 0.1 percent in July, the smallest increase in eight months, as gasoline prices fell.

In its statement last week, the central bank did acknowledge the downside risks to the economy had “increased somewhat” with volatile financial markets, credit conditions tightening and the housing market correction continuing.

Analysts saw those comments, in light of the increased market turbulence since the Fed meeting, as boosting the chance that the central bank will cut rates later this year.

That is certainly the prevalent view among investors placing bets in the federal funds futures market, where the prospect of Fed rate cuts has risen from almost nonexistent a few weeks ago to now a high probability of three quarter-point cuts before the end of this year.

Some analysts said unless conditions in financial markets get much more severe Bernanke and other Fed officials will wait to cut rates after they see more information pointing to an economic slowdown.

“The Fed does not want to be seen as bailing out financial markets for their bad investment decisions,” said Lyle Gramley, a former Fed board member and now a senior adviser at the Schwab Washington Research Group.

Gramley, however, said he believed incoming data would show a serious enough impact on the overall economy from the slump in housing and the credit troubles that the Fed will be ready to cut rates by a quarter-point at both its October meeting and in December at its final meeting of the year.

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