Sept. 16: No one predicts a quick fix

Can falling interest rates cure falling confidence?

They've worked in the past. Now the Federal Reserve is expected to embark on a new series of interest rate cuts in an effort to keep the worst blowup in housing in decades from dragging down the rest of the economy.

Most forecasters expect the Fed to cut a key short-term interest benchmark, the federal funds rate, by a quarter-point or even half a point when it meets Tuesday. By the end of the year, many economists believes the Fed will ratchet down the rate by three-quarters or a full percentage point.

For borrowers, those moves could mean that their monthly payments on home-equity lines of credit, credit cards and other debt tied to short-term rates could fall. The effect on mortgage and corporate debt rates would be more indirect, and take more time to make itself felt.

Most mortgage rates, for example, are related to either the rate on 10-year Treasury debt, or a market-set loan rate that banks use to lend money to each other called the London InterBank Offered Rate (LIBOR).

Those rates are influenced by the short-term rates set by the Fed, but they are not determined by it. The one-month LIBOR rate, for example, has been about half a percentage point above the current 5.25 percent federal funds rate in recent weeks.

With Fed action likely to take months before it significantly eases the pressure on the financial system, no one expects a quick fix to unfold.

"Whatever they do, the market is going to ask for more," said Mickey Levy, chief economist at Bank of America.

With hedge funds and lenders having been burned by record defaults on home loans by borrowers with sketchy credit ratings, lower interest rates will do little to make whole their losses, said Scott Anderson, senior economist in the Minneapolis office of Wells Fargo & Co.

"This is a financial crisis that [Fed officials] never faced before," he said. "Financial intermediaries have been busy reinventing the global financial system," and the result has been to spread risk like a virus, with lenders still unsure how many of their borrowers are coming down sick.

Reducing short-term U.S. interest rates will help to lower the cost of money but not necessarily make lenders eager to write new loans.

"The real problem is the availability of credit, not the pricing of credit," said Vincent Boberski, senior vice president in the Chicago office of FTN Financial, a brokerage and investment-banking firm.

Of the expected cuts in the federal funds rate, he said, "It's going to take some of the pain out of the current situation but not fundamentally fix it."

Other economists agree that a developing "credit crunch," in which lenders are reluctant to lend at any price, may be the larger problem facing the Fed. Last month, the central bank and others in Europe and Asia were forced to pump tens of billions of dollars into the financial system in an effort to keep credit markets from seizing up.

Even so, many problems remain. Consumers are finding it harder to get a mortgage, some companies are finding themselves unable to issue new short-term debt, and the financing for many mergers and acquisitions is stuck in limbo.

"There is a housing slump, which will take a long time to get much better," said Kenneth Goldstein, senior economist at the Conference Board, a New York-based business group. But, he added, "The wild ride [in financial markets] in August was not because of housing" but the result of the sudden, broader revulsion for risk among lenders who previously could see almost none.

That widespread reassessment of financial risk can't be preemptorily ended with a few cuts in short-term interest rates, he said.

Until regulators and central bankers find a way to calm markets, the risks of a U.S. recession will rise, said Nariman Behravesh, chief economist at Global Insights, a leading forecasting firm.

A few months ago, Behravesh put the odds of recession in the year ahead at one in five. Now there is a one-in-three chance, he said.

Even if recession is avoided, many forecasters believe a slowdown is likely that will mean an economy growing at 2 percent, or less, by the end of the year. That would lead to more sluggish job and income gains than the 3 percent typical for the United States.

What could keep the economy from shifting into reverse?

The slide in the value of the dollar should ensure continued robust exports. The service economy -- everyone from cooks and health-care workers to social workers and lawyers -- has shown no sign yet of falling prey to the gyrations of the financial markets. Even soaring oil prices, now near $80 a barrel, have been taken in stride.

But the optimists admit their forecasts contain risks.

For instance, some members of the Federal Open Market Committee, which decides on the federal funds rate, may be more worried about inflation rates climbing than growth stalling.

Rising oil prices may force many to choose paying their gasoline and heating bills over trips to the mall, while also driving up the cost of a wide range of petroleum-based products, from paints to plastics.

A weak dollar also will raise the cost of imports, reversing a long-standing trend of cheap foreign-made goods acting as a brake on consumer and industrial prices.

"I don't think the Fed wants to do any more than it has to do," said economist Jim Paulsen, chief investment strategist at Wells Capital Management. "I think they'll wait and watch the data."

If the Fed can catch up to the rates at which the market is pricing government short-term debt, that may be enough, in Paulson's view.

"Much of this is more of a confidence crisis than a fundamentals crisis," he said.

Mike Meyers • 612-673-1746

Mike Meyers • meyers@startribune.com