WASHINGTON – With turbulence hitting financial markets as a global credit crisis claims heavyweight victims, suddenly the possibility of a reduction in interest rates by the Federal Reserve is back on the agenda.
Economists were split on whether the central bank would actually cut a key rate when officials meet Tuesday, but it was widely agreed that the Fed will at least open the door to reducing rates in the weeks ahead if financial markets do not stabilize.
Wall Street had a very tough day Monday, with the Dow Jones industrial average tumbling by 504 points in the steepest slide since the September 2001 terrorist attacks.
"Given the meltdown in markets, a rate cut is becoming fairly possible," David Wyss, chief economist at Standard & Poor's in New York, said in a comment echoed by other economists.
That represents a significant change from just a few days ago when the widely accepted view was that the Fed was finished cutting interest rates and the next move would be to start raising rates, but probably not until next year.
However, the stunning developments of the past two days as the 14-month credit crisis claimed its biggest victim yet have led economists to rethink their views. Lehman Brothers filed for bankruptcy protection on Monday after marathon talks over the weekend failed to produce a willing buyer for the nation's fourth largest investment bank.
No white knight would step forward after Treasury Secretary Henry Paulson held firm to the position that the federal government would not step in and supply any money to help facilitate a sale, unlike what was done six months ago when the Federal Reserve put up a $29 billion loan with Paulson's backing to support the sale of another investment bank, Bear Stearns, to JP Morgan Chase.
Briefing reporters at the White House, Paulson insisted that the administration had made the right decision.
"I never once considered that it was appropriate to put taxpayer money on the line in resolving Lehman Brothers," Paulson said Monday.
The Fed did announce on Sunday that it was expanding its efforts to supply more cash to the financial system as a way of helping other financial firms that might be facing problems in the wake of the Lehman bankruptcy filing.
However, many economists believe the effort will end up not being enough to calm markets. For that reason, they say the chances of a Fed rate cut — most likely occurring between meetings — has risen. Another factor that might influence the Fed is the recent jump in unemployment, which surged in August to a five-year high of 6.1 percent as companies shed another 85,000 jobs.
"Looking back to the '70s, over the last five recessions, the Fed has pretty much slashed interest rates until the unemployment rate has peaked each time," said Christopher Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi.
David Jones, an economist at DMJ Advisors, said he believes the Fed will signal that it is now more inclined to cut rates than to raise them but will stop short of actually cutting rates.
"I believe they will say that the financial crisis has greatly increased the downside risks to growth and those risks now far outweigh the risks of inflation," he said.
The central bank has gotten some good news on inflation recently with the sharp fall in oil prices with crude closing below $100 per barrel on Monday for the first time in six months.
That big decline in energy prices helped trigger the largest drop in wholesale prices in nearly two years in August and economists believe that a report to be released Tuesday will also show that consumer prices dropped in August.
The Fed started a year ago with an aggressive effort to cut interest rates, pushing the federal funds rate down from 5.25 percent to 2 percent, where it has been since the Fed's last rate cut in April.