Fed rate may fall half point

Bloomberg News Service

When Federal Reserve policy makers meet tomorrow to consider whether to cut interest rates a third time this year, looming in the background will be the rapidly worsening economic situation in Japan.

Alan Greenspan said the Fed is likely to cut rates more rapidly.

The Fed's policy-setting Open Market Committee probably will cut its benchmark overnight bank lending rate a half percentage point, "but I doubt that it will offset all the pessimism," said Mickey Levy, chief economist for Banc of America Securities.

Some analysts and investors have been betting that the cut will be three-quarters of a percentage-point. HSBC Securities Inc. boosted its forecast Thursday, saying the Fed had "little to lose." After tomorrow, the FOMC doesn't meet again until May 15.

Nevertheless, some analysts worry that the economic picture in Japan has reached the point where it has increased the risk of recession both in the U.S. and global economies — forcing U.S. policy makers to take more serious account of Japan.

"Both the U.S. and Japan are either in recession or on the brink of recession, and the growth rate in Europe isn't likely to be strong enough to make up the difference," said Stephen Roach, Morgan Stanley Dean Witter's chief economist.

While the Fed won't necessarily increase the size of the rate cut it's expected to make tomorrow, Roach says, it's likely to cut interest rates more rapidly — and ultimately to a much lower level — to stave off a global slump.

Roach's own calculation is that the world economy will grow by about 2.7 percent this year, compared with 4.9 percent in 2000. "The threshold for a global recession is 2.5 percent," he said. "The global climate is pretty treacherous."

As a result, he figures, "the Fed's ultimate target" for the overnight lending rate should now be 3.5 percent. It's now 5.5 percent. The consensus has been that it ultimately will fall to 4.5 percent.

Economists say the effect of Japan's slowdown could worsen the economic situation in the U.S. and around the world in several ways:

• By exacerbating a global slowdown, it could make it more difficult for the U.S. economy to recover from the current slowdown. Policy makers no longer would be able to count on exports to help pull the United States out of its slump.

• If Japanese investors choose to sell their U.S. holdings to help bolster their own balance sheets, it might worsen the slump in U.S. markets. The phenomenon might intensify near April 1, when new accounting rules are to go into effect in Japan.

• The falloff in demand in both Japan and the United States already is hurting the other major Asian economies, which have depended heavily on exports to both countries. Asian exports to the United States helped the region recover from the 1997-98 financial collapse.

• The recent plunge in the value of the yen could set off competitive devaluations throughout Asia, possibly prompting China to abandon its longstanding pledge to keep its own currency stable. Added devaluations could seriously hurt Asian economies.

Europe isn't that buoyant

Nor is Europe as likely as some thought to be able to step in as the engine of global growth. Deutsche Bank AG is forecasting the region's growth at 2.6 percent this year, following a 3.5 percent gain in 2000.

Moreover, European policy makers seem to have little flexibility. Central banks there are still focused on combating inflation, while fiscal policy has been stymied by the obligation of governments to meet European Union deficit-cutting targets.

On Thursday, the European Central Bank left interest rates unchanged, refusing to trim its benchmark 4.75 percent lending rate, even though the Fed has been cutting rates since early January. The ECB won't meet again until April 11.

Politically, the fast deterioration in Japan also seems likely to test the George W. Bush administration's announced new approach of sticking to quiet diplomacy in dealing with Japan, rather than publicly exhorting Tokyo to take action.

Although the administration has held to its promise so far, policy makers are becoming increasingly worried about the seeming paralysis in the Japanese government and the growing reaction in the financial markets.

United States' cure

There's no mystery about the United States' prescription. It wants Japan to deregulate its financial system, strengthen its banking regulations and close shaky institutions — much as Washington did during the U.S. savings-and-loan debacle in the 1980s.

Bush has agreed to meet with outgoing Japanese Prime Minister Yoshiro Mori when he visits Washington this week, but it isn't clear how firmly the administration will be able to hold its tongue.

Mori's visit is regarded as little more than a courtesy on the administration's part, mainly for diplomatic reasons. U.S. officials say only Japan can take the steps needed to spur a recovery. All of Tokyo's other options have been exhausted.

Roach's fears aren't shared by all analysts. Adam Posen, an economist at the Institute for International Economics, says that the possibility of a global recession isn't nearly that strong and that the Fed is proceeding rapidly enough in its push to reduce interest rates.

The U.S. economy isn't hurting as badly as some pessimists contend, Posen says, and while Germany's economy is sluggish now, he thinks Europe is growing rapidly enough to avert a full-fledged recession.

Moreover, Posen argues, because of the traditional lags, the rate cuts that the Fed has engineered so far haven't been fully felt yet. If Japan's economy does slow further — and the yen plunges — inflation here will ease, making the Fed's job easier.

"Until we see what the situation is" later on, "there's no need to panic," Posen says.

For now, the betting is that Fed policy makers share Posen's view. Top Fed officials have insisted in speeches that the U.S. slowdown is likely to run its course soon without falling into a recession. The question is, what happens after that?

If the slowdown spreads worldwide, that will only worsen the outlook more and eventually dim prospects for a quick recovery in the United States, Roach asserts.

At the same time, Fed officials have indicated repeatedly they're reluctant to appear to be rescuing the markets, for fear it will only encourage imprudent behavior by investors. Last week it passed up market demands for a between-meetings rate-cut.

Levy, of Banc of America Securities, says that concern over the situation in Japan "added to the pessimism, but was not the major driver" during last week's market slide.

That's apt to be its place at the table this morning, analysts say.