In contrast to the last two meetings, expectations from economists, analysts, and futures markets are deeply divided over whether the Federal Open Market Committee (FOMC) will hold the target interest rate at 2.00% upon concluding the monetary policy meeting on Tuesday. While some say the Fed will be forced to cut rates, others are deeply critical of such a move.

In a stunning reversal between Sunday evening and Monday morning, Fed Funds Futures went from pricing in a 12% expectation that the FOMC would cut rates to an 80% chance. As of 1:30 p.m. EDT on Monday, the probability moderated back to a 62% chance.

Senior economist Sal Guatieri at BMO said the case for a rate cut on Tuesday is growing stronger. "The 13-month long credit crisis obviously shows no signs of waning. Despite the 2% funds rate and negative real rate, policy is far from accommodative because of tight credit conditions and worsening financial conditions," he said.

Guatieri said that key money aggregates "have virtually stopped growing in recent months," while the 6.1% unemployment rate is already higher than the Fed's forecast for Q4.

Further support for the dovish argument comes from lower commodity prices, including oil at a seven-month low below $100 on Monday morning, and some recent gains for the U.S. dollar.

"If the Fed doesn't cut rates tomorrow, it will likely shift to an explicit easing bias. The press statement will stress the economic risks and downplay inflation worries, perhaps by omitting the word 'significant' when describing the Fed's concern about the inflation risks," Guatieri said.

His colleague Sherry Cooper added, "One thing is certain, the Fed will do whatever it takes to calm financial markets."

But cutting rates on Tuesday may not be early enough, wrote Brian Bethune, chief U.S. economist at Global Insight. "Without a very aggressive response from the Fed on rates, the threat to the financial system and the economy from further declines in asset prices is huge," Bethune said, who had called for the Fed to step in and execute an emergency rate cut a day ahead of the statement's scheduled release.

"ithout such action there would be unstoppable pressure for Congress to act, and the cost to American taxpayers would continue to escalate massively," he added.

Laurie Goodman, head of global fixed-income research at UBS, said the FOMC's decision will depend on the movements in the stock and credit markets on Monday. She said the situation remains fluid and that events could change the situation rapidly. "Looking beyond this week, we still feel very strongly about the Fed cutting the fed funds rate to 1.5% by year-end in response to further softening in economic conditions," she added.

Commenting on the agreement of 10 major banks to set up a $70 billion borrowing facility to bolster liquidity and help tame the credit crunch, Bethune said the fund should help but that it's not enough to address this emergency situation. He said if the Fed fails to act aggressively, it would "threaten the economy and the financial system even further."

Many don't expect or desire the Fed to cut rates, however.

A media advisory note from the Council on Foreign Relations criticized the U.S. central bank for using monetary policy "to prop up the financial system rather than to protect [the] value of the currency," which they said could call into doubt the dollar's viability as the global reserve currency. The note says policy-makers have the power to shape the character of globalization in the coming months.

"As New York's investment banks are humbled while European universal banks weather the storm successfully, New York's status as the world's leading financial center may be threatened. For the past two decades or so, the world has witnessed the advance of a U.S.-centric globalization, with U.S. policymakers, firms, and markets at the center of the system," the advisory read. "Depending on how policymakers handle the coming months of the crisis, the character of globalization may be in the process of changing."

Chris Low, chief economist from FTN Financial Capital Markets, also views a rate cut as a mistake. "I think a cut [Tuesday] would do more harm than good, unless it is accompanied by cuts in Europe and the UK. If the Fed cuts on its own, it could hurt the dollar, which is just another way of saying it could drive more foreign capital out of the U.S."

Even more hawkish, Rudy Narvas, strategist at 4Cast, said he expects the Fed to hold rates at 2%, adding that the FOMC will continue to keep an inflation bias in the statement. He said the benefit of a quarter-point cut is "marginal at best," as the current liquidity crisis has little to do with the Fed Funds rate.

The dramatic movement of the effective Fed Funds rate - the actual interest rate at which depository institutions lend to each other for overnight transactions, as opposed to the target rate established by the Fed - would appear to confirm that analysis. The effective rate hit 6% on Monday, the highest rate since the credit crisis began, when the target rate was 5.25%.

Narvas also said a rate cut would be seen as pandering to the markets. Narvas said holding an inflation bias would be more prudent, because even though oil has fallen into double-digit prices and inflation has "come down dramatically," these may only be short-term price movements.

By Patrick McGee and edited by Stephen Huebl
©CEP News Ltd. 2008