Fed Talk: The Half-Percent Solution?

Top Wall Street economists and strategists look into the future and try to predict Bernanke & Co.'s next move

From Standard & Poor's Equity Research

The debate continues: After its surprising 75-basis-point cut on Jan. 22, should the Federal Reserve ease interest rates by an additional 50 points at the conclusion of its Jan. 29-30 policy meeting? Should Ben Bernanke & Co. opt for a more conservative 25-basis-point move? Or should they stand pat?

Here is a roundup of what top Wall Street economists and strategists had to say on Jan. 29 about the current situation, as compiled by S&P MarketScope and BusinessWeek staff:

Uncertainty Before Fed Decision

Andrew Tilton, economist, Goldman Sachs: An extraordinary amount of information on both macro policy and the economy will be released over the remainder of this week. In our view the most important questions for markets are: 1) Will economic indicators continue to look recessionary? 2) Will the Fed deliver the additional easing expected by markets? 3) Will the federal government offer any further initiatives to address economic weakness? Although we continue to believe the economy is in recession (or will enter recession shortly), market sentiment is already quite pessimistic and so even the relatively soft data-set that we expect might be a modest relief in comparison to the dire news flow from the first three weeks of the month.

We expect the Fed to deliver another 50 basis points of monetary stimulus on Wednesday, although this is hardly a done deal and could be affected by data to be released between now and then. Major new provisions from the federal government look unlikely, though the size of the stimulus package might creep up a bit further.

Beware of Bubbles

Bill Gross, managing director and chief investment officer, PIMCO: The monetary attempt to halt housing's—and therefore the economy's—downward slide rests on the shoulders of the 30-year mortgage. If so, then Mr. Bernanke—we have a problem. First of all these 6% to 7%, 30-year mortgages now require a significantly higher down payment than in prior years. Twenty percent down? Say what? Where does a 30-year-old couple get that kind of money? Secondly however, and just as important, what motivates a future homeowner to pay 6%-plus interest for an asset that is going down in price? It was an easy decision to pay subprime yields of that, and then some, when housing prices were accelerating at double-digit annual percentages; the benefit was obvious. Now, however, with prices in negative territory, the risk/reward is tilted toward the renter.

My point is that Chairman Bernanke must recognize the reduced benefits and obvious dangers of a déjà vu trek to 1% short rates. Those yields produced 5%, 30-year mortgage rates to the homeowner for a two to three month period in 2003 and they could do so again, but bubble-creating, inflation-inducing damage to the U.S. dollar would be the likely result now. Best to stop far short of 1% and at the same time encourage reforms in FHA, government-assisted programs that would permit subsidized mortgage rates with minimal down payments.

A Second-Half Lift

Mark Zandi, chief economist, Moody's Economy.com: The aggressive monetary and fiscal steps taken now should provide a measurable lift to the economy by the second half of this year. Assuming the funds rate is 2.5% by midyear, and that the $150 billion stimulus bill is implemented this summer, annualized real gross domestic product (GDP) growth will receive a boost of two percentage points in the second half of 2008. Based on a simulation [by] our macroeconomic model, this could make the difference between a 12-month and 9-month recession, save nearly 1 million jobs, and result in an unemployment rate that is more than half a percentage point lower than would otherwise be the case.

Policy may not be as potent in lifting growth this time as it has been historically, however. The roots of the economy's difficulties are in the housing and mortgage markets, and now in the broader, global financial system. Normally the most immediate conduit between monetary policy and the economy runs through the housing market.