Fed rate cuts don’t come without economic risk

Some economists predict the funds rate will drop this year to 2 percent, a four-year low. Most believe Bernanke will not have to cut rates as deeply as did his predecessor, Alan Greenspan when Greenspan took on the 2001 recession; the economic fallout of the Sept. 11 attacks; a series of accounting scandals that rocked Wall Street; and the uncertainty that gripped the country leading up to the U.S.-led invasion of Iraq in March 2003.

By the summer of 2003, Greenspan had slashed the funds rate to 1 percent, a 45-year low. He held rates there for a year before the Fed began pushing them back up.

Critics contend those low rates helped to feed the housing frenzy, where home values zoomed and investors gobbled up risky loans, known as subprime mortgages, to borrowers with poor credit histories. When the housing market collapsed, the greatest damage was in subprime loans. Banks and other financial institutions have taken multibillion losses on these mortgage investments, which now have tanked.

In the gravest challenge to his leadership since becoming Fed chief nearly two years ago, Bernanke must help stem the fallout from both the housing bust and a credit crunch. The credit squeeze has made it tougher for people to get financing to buy homes and other big-ticket goods, and for businesses to expand and hire.

Some analysts think the economy is on pace to shrink from January through March after barely growing over the final three months of 2007. Under one rough rule, the economy would have to contract for six months in a row before the country is considered to be in a recession.

The odds of a recession have risen sharply over the last year, and analysts increasingly believe the U.S. will be in one during the first half of this year.

It will be crucial for Bernanke to send a clear message to Wall Street and Main Street.

"If people don't understand the message, the tool — changes in interest rates — is not as powerful. That is a risk," said Mark Zandi, chief economist at Economy.com.

Greenspan made a similar point right after the 2001 terrorist attacks.

"We ought to make certain, as much as we know how to do so, not to inadvertently create changes in views and expectations," Greenspan warned his Fed colleagues about a week after Sept. 11, according to transcripts of private Fed meetings. "Such things happen by accident. We cannot afford accidents at this moment."

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