Originally created 03/18/03

War uncertainty probably will keep Fed from lowering rates - for now



WASHINGTON -- Uncertainty about the effects of war probably will keep the Federal Reserve from cutting interest rates at Tuesday's meeting. But Fed policy-makers will not hesitate to drive rates lower - even to zero - if necessary in coming weeks to protect the economy, analysts said.

Private economists said Monday the Federal Reserve chairman, Alan Greenspan, and his colleagues will start cutting interest rates only if they believed an Iraq war was harming the economy or threatening to disrupt financial markets.

"If the war goes badly, the Fed is going to need all the ammunition it has," said Sung Won Sohn, chief economist at Wells Fargo in Minneapolis. "I would expect the Fed to cut interest rates to zero in an extreme situation."

The Fed already has pushed the federal funds rate, the interest that banks charge on overnight loans, to a 41-year low of 1.25 percent in response to a recession and terrorist attacks in 2001. Its last rate cut was a bigger-than-expected one-half point on Nov. 6.

Sohn and other economists said the possibility of a series of rapid-fire rate cuts would come into play only if a U.S. war with Iraq should go badly or trigger new terror in the United States that undermined consumer confidence.

In a best-case scenario of a quick war, oil prices would retreat from their current highs and American businesses would unfreeze their expansion plans and boost the economy by rehiring laid-off workers and boosting investment.

Expectations of just such an outcome lifted spirits on Wall Street for a fourth straight session Monday, with the Dow Jones industrial average surging by 282.21 points to close at 8,141.92. The Dow has gained more than 600 points in four days of trading, allowing it to close above the 8,000 level for the first time since Feb. 21.

Market sentiment about whether Fed policy-makers would cut rates at this week's meeting has been heavily influenced during the last two weeks by economic reports and the looming war.

A report that unemployment rose to 5.8 percent and 308,000 jobs were lost in February raised worries this month about a possible new recession and prompted a number of analysts to forecast at least a quarter-point rate reduction Tuesday.

With geopolitical events in Iraq moving rapidly as well, many analysts now believe that the Fed will not want to cut rates this week but will signal that rate cuts could start quickly if needed.

The Fed probably will send such a signal by changing the wording of its statement designed to foreshadow future rate moves from the current neutral position to one stating that economic weakness poses the greatest threat to the economy.

Such a move would make it easier for Greenspan to cut rates between meetings through the use of an emergency telephone conference, a device the Fed last used immediately after the Sept. 11, 2001, terror attacks. Fed policy-makers do not have another rate setting meeting scheduled until May 6.

"I think the Fed can achieve all it needs to achieve at Tuesday's meeting by changing the bias to acknowledge that the risks have tilted toward weakness," said Robert Gay, chief research economist at Commerzbank in New York. "Once you change the bias, it opens the door to an interest rate action at any time."

Economists said that Greenspan and his colleagues have made clear in various speeches that they will not hesitate to go beyond reductions in the federal funds rate, which governs short-term rates like the prime rate, to protect the U.S. economy.

Those efforts, Fed officials have said, could include direct purchases by the central bank of long-term U.S. bonds in an effort to have a greater influence on long-term interest rates.

"The Fed is trying very hard to prevent this from turning into a major recession or, worse, falling into a Japanese-style deflation trap," said David Wyss, chief economist at Standard & Poor's in New York.

With inflation outside of energy remaining benign, economists are predicting that the current low interest rate environment, which has spurred record home sales and mortgage refinancing, will continue at least through the summer.

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