The Fed meets Tuesday: Rate Cut Worries

Expect a cool Monday for trading as the market braces itself for a FOMC meeting on Tuesday.  So the question we are all wondering -- How far will the Fed cut interest rates?  What if they don't? What if it's not good enough for Wall Street?

Liz Rappaport at theStreet.com is saying a 50-basis-point rate cut is a possibility, according to some economists. The fed funds futures market is pricing in 100% odds of a 25-basis-point cut next week and 28% odds of a 50-basis point cut, which would bring the fed funds rate to 4%. The Fed has cut rates by 0.75% over the past two meetings of the Federal Open Market Committee. The futures market is also pricing in two more 25-basis-point cuts at the Fed's January and March 2008 meetings.

Inflation expectations for the coming year rose to 3.5%, while long-term expectations increased as well. The share of people who say that now is a good time to buy a house because of low prices or a good deal hit 55%, a record high.

The Labor Department said that average hourly earnings jumped a substantial $0.08, or 0.5%, to $17.63. But earnings are up just 3.8% from a year ago, suggesting that wage pressures are in check. That gives the Federal Reserve additional leeway to cut interest rates at next Tuesday's meeting. The Fed is expected to cut its main interest-rate target by at least a quarter of a percentage point.

Some analysts said that the jobs numbers would help tip the Fed toward a quarter-point reduction, rather than a half-point cut, as some Fed watchers had predicted. "This report wasn't overwhelmingly strong, but it was not weak enough that the Fed needs to think about" cutting rates by a half-point, said Peter Kretzmer, senior economist at Bank of America. The smaller cut "will be just what the doctor ordered."

In recent months, the labor market has remained relatively resilient in the face of the housing slump and credit crunch. Economists say one reason is that employment tends to be a lagging indicator, and that economic growth was strong earlier, especially in the third quarter.

But many analysts say employment is likely to weaken as the economy slows.

By itself, the job growth will likely not be enough to dissuade the Federal Reserve from cutting interest rates. Peter Morici, a professor of business at the University of Maryland, explained that the November job growth still showed strains from spiking subprime defaults.

"Residential construction, financial services, and manufacturing displayed weakness, indicating growth is slowing significantly in the fourth quarter and further raising prospects for an interest rate cut at the Dec. 11 meeting of the Federal Open Market Committee," said Morici. At the meeting, the Federal Reserve's policy-setting panel is widely expected to cut its federal funds target rate by at least 25 basis points from the current 4.5%.

A hobbled consumer could trip up the economy. The University of Michigan announced Friday a preliminary December reading on its consumer confidence index of 74.5. That is down from 76.1 in November and undershot Thomson's expectations for a reading of 76.0.

"Weakness in equity prices, further pressures in the housing and mortgage markets, and a sharp jump in gasoline prices overwhelmed the benefits of relatively good employment market conditions," said Brian Bethune, a U.S. economist at Global Insight.

Nonetheless, bond yields jumped as prices fell, an indication investors are more worried about inflation than recession. The yield on the 10-year Treasury note rose to 4.10% from 4.00% late on Thursday. That, however, remains far below the nearly 4.5% registered at this time last year, and also below the fed funds rate.