WASHINGTON -- The Federal Reserve is widely expected to cut its benchmark interest rate Tuesday for the first change since June last year. Given what's roiling Wall Street, however, it might prove akin to offering a Band-Aid to stop a stomachache.
In recent speeches, Fed governors have all but confirmed that a cut is coming from the Federal Open Market Committee, the Fed's policymaking group.
Most Wall Street economists expect a cut of a quarter-percentage point, bringing its benchmark fed funds rate - the fee that banks charge each other for overnight loans - down to 5 percent. The funds rate influences interest rates on a wide array of commercial and consumer loans.
Some analysts argue for a more aggressive rate cut of half a percentage point, to 4.75 percent, in an effort to boost consumer spending, which drives about two-thirds of the U.S. economy.
But even the steeper cut might do little for the underlying causes of Wall Street's heartburn. The problem isn't that it's gotten too expensive to borrow - something a rate cut would help - but that lenders are afraid to lend, and investors afraid to invest.
Since June, Wall Street has fretted about huge losses from subprime mortgages, those issued to borrowers with the weakest credit histories. These loans were bundled together and sold to investors as high-yield mortgage bonds.
Many of these subprime loans involved adjustable rates that are poised to adjust to much higher monthly payments, sparking fears of foreclosures and defaults on these mortgage bonds.
These fears began spilling over into other areas last month and now threaten the broader U.S. economy. The fears are most evident in markets for commercial paper, the short-term debt that corporations issue to generate working capital. Even with high rates of return, investors aren't interested now in buying these debt instruments.
That might blunt the impact of any Fed rate cut.
'So much risk'
"Monetary policy is unlikely to have much effect this time around - even if the Fed reduces interest rates by 50 basis points [half a percentage point] - because the problem is that there is so much risk out there that is unknown," said Robert B. Reich, a former economic adviser and labor secretary to President Bill Clinton. "Credit markets and financial intermediaries are fearful of making much money available or engaging in new loans because they simply don't know how much risk they've taken on."
Problems in the commercial paper market affect the broader real economy. When buyers of commercial paper demand a higher return, it raises the cost of doing business for companies. That makes them less profitable, and that, in turn, makes them less likely to increase wages, hire or expand.
A Fed cut of 25 basis points will do little to fix what ails Wall Street or the broader economy.
"The main conduit through which monetary policy affects the economy, the housing market, is in disarray, and 25 basis points just isn't going to matter," said David Wyss, chief economist for Standard & Poor's, the New York rating agency. "It's going to make very little difference. That's an argument for a 50 basis-points cut.
"Right now, everything has been tarred with the same brush. When you get these kinds of panics, ... it seems to take between two and six months to calm down."
Even so, Wyss said a more aggressive rate cut by the Fed might help some homeowners with adjustable-rate mortgages, which are at the heart of Wall Street's concerns. These adjust based on indices that are influenced by the Fed funds rate. So a steeper rate cut would mean that mortgages that adjust in coming months would still go up, but not by as much.
Also favoring aggressive Fed action is Rep. Barney Frank, a Massachusetts Democrat and the chairman of the influential House Financial Services Committee. He's the first chairman in more than a decade to publicly pressure the largely autonomous Fed to lower rates. In a statement Sept. 7, he called on the Fed to make a "meaningful interest-rate cut."
There are other strong arguments for an economic stimulus now to thwart recession. Inflation is contained, inflation expectations are unchanged over a longer horizon, productivity is slowing and the August loss of 4,000 jobs shows the broad economy is weakening.
But if Fed Chairman Ben S. Bernanke moves too quickly to cut rates, that could interrupt what amounts to a repricing of risk and encourage the kind of poor lending that created today's mess. Economists call this encouragement "moral hazard."
"I think [Bernanke] believes that there are moral-hazard issues, and he does not want to fan more risk-taking in the future," said Mark Zandi, chief economist for Moody's Economy.com, a forecasting firm in West Chester, Pa. He expects a 25 basis-point cut Tuesday. "[Bernanke] wants to extract a pound of financial flesh now."