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US Fed expected to cut rates

25/06/2003 13:30
Speculation over a possible cut in US interest rates is mounting as the Federal Reserve prepares to make its monthly decision on the cost of borrowing.
Policymakers will be pondering a lacklustre recovery by the US economy, as well as relatively high unemployment.

Although most analysts are predicting the central bank will cut rates on Wednesday, the market is divided over the extent of any action to stimulate the economy.

US interest rates have been held steady at 1.25% - a 42-year low - since late 2002.

This follows 12 cuts to the rate since January 2001, when the US economy first began to falter after an unprecedented boom in the late 1990s.

Whether the Fed opts to cut by quarter or half a percentage point on Wednesday, any trimming would still take the rate down to its lowest level since 1958.

Deflation fears

Policymakers will also be conscious of the risk of deflation, described by Fed chairman Alan Greenspan last month as "minor" but a risk which could have grave consequences.

Deflation is when prices of goods start to drop, rather than rise. It can be very damaging because it makes shoppers reluctant to spend if they think prices will continue to fall.

"Whatever the Fed does this week, it is critical that officials clearly explain... how the outlook has changed"
Richard Berner
Morgan Stanley

However, a recent rise in US living costs, shown in data released earlier this month, went some way to ease recent fears about deflation.

"In [Mr Greenspan's] mind, the benefit of giving the economy one more boost is much bigger than the negative concerns," said Wells Fargo Bank economist Michael Swanson.

The Fed may also be swayed by data on Tuesday showing that consumer confidence has held steady since May.

The Conference Board's monthly consumer sentiment index stood at 83.5, slightly down from 83.6 in May, but beating expectations of a fall to 82.4.

Mixed feelings

The survey of 5,000 US households showed that optimism over a newly buoyant stock market was tempered by fears over business confidence and the job market.

The US unemployment rate currently stands at 6.1% - a nine-year high.

"The important issue is whether this basically stable consumer confidence number indicates whether the Fed will cut rates by 25 or 50 basis points," said Lara Rhame, a senior economist at Brown Brothers Harriman.

"To me, this number only reinforces a quarter-point cut because I think it is significant that this reading, even in the face of a very weak labour market, has remained resilient."

Economists pay close attention to consumer confidence because consumer spending accounts for two-thirds of all economic activity in the US.

There are fears that a cut of half a percentage point would signal an end to any further rate-cutting in the near future, which would in turn signal a rise in long-term interest rates.

In light of this, some investors would prefer a quarter percentage point cut, with hints of further loosening later in the year.

"Whatever the Fed does this week, it is critical that officials clearly explain the rationale and how the outlook has changed," said Morgan Stanley economist Richard Berner.