Libor holds the key to Fed rate cut

Federal Reserve officials were close to unanimous that they wouldn't need to reduce their 4.5 per cent overnight lending rate target in December. That was until the week of November 19.

Now there's concern, and the outcome is up in the air. The unanimity is gone, and if the decision is to lower the target again, there could be a dissent or two. If there's a cut, a half-point cut probably isn't in the cards.

The main reason that Fed officials are far less sure is an abrupt rise in interbank lending rates that, if continued, might begin to affect the flow of credit more broadly to U.S. consumers and businesses. So far, there are few if any signs that's happening, officials say.

The Federal Open Market Committee statement issued after the last meeting on Oct. 31 indicated officials weren't thinking about a December rate cut. It said that after the quarter- percent point reduction in the target they had agreed upon, ''the upside risks to inflation roughly balance the downside risks to growth.''

A number of Fed officials underscored that view later in their public comments.

Many investors and analysts, expecting much weaker economic growth than Fed officials, simply didn't believe what they were hearing.

Fed funds futures contracts suggest a very high probability of a 25 basis-point cut on Dec. 11, a reading of Fed intentions that had some officials shaking their heads.

Circumstances began to change when the interbank market started tightening just before Thanksgiving, reversing some of the stabilization that occurred in September and October.

For instance, the daily fixing in Libor "" the London interbank offered rate "" for one-month money, which had hovered around 4.66 percent in the first half of November, began a swift rise. On Nov. 30 it reached 5.236 percent. Normally, Libor is only slightly higher than the Fed's lending-rate target, and if a rate cut is likely within a couple of weeks, it may be lower than the target.

Part of the increase in Libor is undoubtedly related to pressures in the interbank market toward year's end. And some of the current problem is due to large demands for dollar loans by foreign banks.

A November 28 a speech in New York by Fed Vice Chairman Donald L. Kohn alerted markets to the shift in Fed thinking about the December 11 meeting.

"An important issue now is whether concerns about losses on mortgages and some other instruments are inducing much greater restraint and thus constricting the flow of credit to a broad range of borrowers by more than seemed in train a month or two ago,'' Kohn said.

Current circumstances ''require flexible and pragmatic policymaking "" nimble is the adjective I used a few weeks ago,'' he said.

And Fed Chairman Ben S. Bernanke said the next evening in a speech in Charlotte, North Carolina: ''In making its policy decision, the committee will have to judge whether the outlook for the economy or the balance of risks has shifted materially. In so doing, we will take full account of the implications for the outlook of both the incoming economic data and the ongoing developments in the financial markets.''

Implicit in what both the chairman and the vice chairman said was that until the shift in the interbank market, they weren't planning a rate cut. The market had been way out in front of the Fed on that.

And now the market is still out in front. On Nov. 30, futures contracts showed investors put more than a one-third probability on a 50 basis-point cut on Dec. 11, and more than a 50 percent probability on a quarter-point cut.

In a November 26 interview, Gary Stern, president of the Minneapolis Federal Reserve Bank, said the divergence between market views and those of Fed officials ''is a difference at heart about what the financial turmoil means for the real economy. They must think it's going to be very negative for it, while I think it's going to be modest.''

Stern said that when he asks whether the availability of credit has been affected, ''the preponderance of business people I talk to would say no. Lenders have tightened conditions on loans, but some of that was going to happen anyway.''

Overall, Stern said he expects the economy to be weak this quarter and to begin to get stronger in the first part of 2008. That's not a forecast suggesting he thinks a rate cut is urgently needed.

"I've not made up my mind what to do yet,'' said Stern, one of the members of the FOMC. ''Why would I? There's two weeks to go. We'll see what we learn.''