Fed, Wall Street are playing chicken

By Jim Jubak

Will the Federal Reserve stand up to Wall Street this time?

In October, the nation's central bank gave in to The Street's fears and cut interest rates again, even though, as Fed minutes of that meeting now make clear, there was good reason to believe that no further interest-rate cuts were necessary at the time.

Now Wall Street is at it again. Despite strong statements from the Federal Reserve that it doesn't intend to cut interest rates at its Dec. 11 meeting, Wall Street insists a cut is forthcoming and that it's justified by its own fears that the subprime-mortgage mess it created will shut down first the debt markets and then the economy.

The Street went so far as to view the boilerplate mouthed by Fed Vice Chairman Donald Kohn on Wednesday and Chairman Ben Bernanke on Thursday about the need to balance inflation and growth, and pledges that the Fed will stay flexible, as promises of an interest-rate cut. This is just another instance of the financial markets hearing what they want to hear.

The odds, according to Wall Street, are better than 90% that the Fed will cut rates once more in 2007.

• Talk back: Should the Fed cut interest rates again?

That puts the Fed and Wall Street on a collision course. The Fed hopes Wall Street will turn aside at the last minute. The Street is betting Bernanke & Co. will wimp out again. (See my Nov. 6 column, "Fed chief caves in to Wall Street.")

A game that endangers us all

The Fed believes U.S. economic growth can rebound in 2008 without another interest-rate cut and that cutting again raises the risk of igniting inflation and further weakening the U.S. dollar. Wall Street believes the debt markets and the big banks that support them are in such bad shape that disaster looms without another rate cut and another and another. Inflation be damned, Wall Street argues, the economy is at risk.

The result is an epic game of chicken played with the U.S. economy. I just hope the folks who have to make a living and pay their bills in the real economy -- you and me, that is -- don't wind up buried in flaming wreckage.

The Fed has made its position very clear. (Well, as clear as the Fed ever gets, anyway. It did, typically, muddy the message with Kohn's and Bernanke's speeches.) You could even say the Fed has spent the weeks since the last interest-rate cut drawing a line in the sand. Over the weeks since Bernanke & Co. gave the stock and bond markets their latest interest-rate gift on Oct. 31, in speech after speech Fed officials have said inflation remains a danger as worrisome as slowing economic growth.

On Nov. 20, the central bank published minutes from the Oct. 31 meeting of its Federal Open Market Committee that showed that most Fed officials did not think further aggressive rate cuts were needed to help the economy regain strength in 2008. That same day, the bankers released the Fed's first-ever enhanced economic forecast. The big surprise? The Fed forecast growth would pick up in 2008 to a rate of 1.8% to 2.5%. And here's the real shocker: The Fed thought that 2.5% was about as fast as the economy could grow without triggering inflation.

News falls on deaf ears

But Wall Street hasn't been listening. On Nov. 19, Wall Street had priced in a 90% chance of another rate cut at the Fed's Dec. 11 meeting, according to prices on the fed funds futures market. Nothing in the Fed's minutes or in the enhanced economic forecast has changed Wall Street's mind.

And that cut won't be the last, according to Wall Street. Goldman Sachs (GS, news, msgs), for example, has predicted the Fed will drop short-term interest rates to 3% by mid-2008 from the current 4.5%. The Fed must cut rates aggressively to avoid a recession, Jan Hatzius, chief U.S. economist at Goldman Sachs, told Bloomberg. The odds of a recession have risen to 40% to 45%, according to Goldman.

A plus for Wall Street?

I certainly wouldn't discount anything that Goldman Sachs says about the debt-market crisis. After all, this is the only big investment bank on Wall Street that's been able to make money by trading on the zigs and zags of the market for mortgage-backed securities.

But remember that Wall Street is an extremely interested party here. Besides rescuing the economy -- if the Fed is wrong and the economy needs rescuing -- more interest-rate cuts would certainly help rescue Wall Street. A rate cut would help prop up the price of the shaky debt backed by subprime mortgages and buyout loans that clog Wall Street's books.

For instance, if short-term rates go down to 3% and long-term rates stay near the recent 4% for a 10-year Treasury note, then debt paying 7% or more looks a lot more attractive, even if it comes with a big helping of risk. If prices for this debt stay up, banks won't have to write down as much of it, reducing losses. Or, to take another example: If interest rates go lower, then banks will have an easier time selling the $170 billion in buyout loans they still have on their books without offering purchasers a big discount.

Continued: Boosting capital

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