Rate cut or no?

The Fed should cut rates! No, it shouldn't!
Here's why so many people think the Federal Reserve should cut interest rates on Tuesday.
Not everyone agrees that a rate cut is appropriate.

By Charley Blaine

The calls for the Federal Reserve to cut interest rates have morphed from polite talk to mob chanting since Sept. 7, when the Labor Department reported a surprising decline in payroll employment in August.
Now the Fed is widely expected to cut its key rate from 5.25% to 5% or even 4.75%. The fed funds rate -- what banks charge each other for overnight loans -- has been at 5.25% since June 2006. The fed funds rate is what banks and other lenders use to price everything from business loans to credit card rates.
Martin Feldstein, a former chairman of the president's Council of Economic Advisers, believes the Fed should work the rate down to 4% or lower over the next 12 months. But not everyone wants a rate cut. So the argument will rage until the central bank's Federal Open Market Committee, the group that actually sets rates, gathers in Washington, D.C., on Tuesday.

Here's how the debate breaks down.
The case for a rate cut
Supporters of a rate cut give four main reasons:

The global credit system still needs help. A rate cut, the argument goes, would help ensure the credit system has enough cash to keep functioning. The system nearly froze up in August when many lenders balked at buying short-term debt like commercial paper, because lenders didn't trust what was being offered as security on the debt. The credit crunch quickly spread around the world.

Problems in the housing and real-estate industries are spreading into the broader economy. Cutting rates would allow more people to buy homes at prices close to what sellers want. That would shore up lenders' finances and demand for new and existing homes. Housing starts are off about 30% from two years ago, while sales of existing homes are projected to be down about 8.6%. A slipping economy means fewer trips to Home Depot, Lowe's and other hardware stores, fewer furniture and appliance sales, and damage to state and local fees and tax revenues. The Wall Street Journal noted that the city of Sultan, Wash., had to lay off its janitor because building permit fees collapsed.

The broader economy is slowing down. The domestic automobile industry is reeling from the combination of Japanese competition and the automakers' over-reliance on gas-guzzling vehicles for profit. Consumers increasingly are strapped amid higher prices and only limited gains in wages.

Lenders need time to understand how bad their problems are. Wall Street investment houses made billions selling securities backed by pools of mortgages to investors around the world. The big unknown is whether the mortgages backing the pools are any good. Do Wall Street firms need to buy back the securities if the loans go bad?

Why the Fed shouldn't cut rates
Opponents of a cut also give a handful of reasons:

It would bail out the stupids. The credit crunch of 2007 began with increasing defaults of mortgages made to people with little or no credit histories. Critics say that was stupid lending and that those who are responsible should be held accountable.

It would boost inflation. A rate cut by the Fed will come as central banks around the world are raising rates or at least keeping them steady. That trend has cut the value of the U.S. dollar, which has set record lows against the euro. It has also caused sellers of key commodities to boost prices to maintain their purchasing power. It's no fluke that gold jumped over $700 this week and that crude oil traded over $80 a barrel for the first time ever.

The U.S. economy isn't that weak. Yes, housing and real estate are weak, but, critics say, speculation in state likes Florida, Arizona, Nevada and California was totally out of hand. Yes, the automobile business is a mess. But U.S. manufacturing overall is still very strong -- just ask Boeing. The service economy is still quite strong -- McDonald's said its same-store sales in August were up more than 8%.

If anything, the global economy may be too strong. The economies in China, India and elsewhere in Asia are booming, fueling superstrong demand for commodities and finished goods. Cutting rates would be like throwing lighter fuel on an open fire.

Some financial pain is necessary. Just as tech stocks became grotesquely overpriced in the late 1990s, so, too, did residential real estate in the first six years of the New Millennium, thanks to ridiculously cheap money and the growing belief in minimal risk. The excesses, as Bank of England Gov. Mervyn King said this week, need to be cleaned out, and he signaled he has no intention of standing in the way of that process.