Bernanke May Be Forced to Lower Interest Rates by Half Point

By Scott Lanman

Jan. 10 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke may be forced to reduce interest rates by half a percentage point this month, validating investor concern that he hasn't been aggressive enough to avert recession.

Economists lowered growth forecasts and traders doubled the size of the rate cut they anticipate after reports showed a decline in manufacturing and a jump in unemployment. A cut in the benchmark rate to 3.75 percent from 4.25 percent would mean Fed officials setting aside inflation concerns from higher oil and food prices.

``In hindsight, if we're moving into a recessionary period or in one, it certainly would suggest the Fed's been too tight for too long,'' said Keith Hembre, who helps oversee $105 billion as chief economist at FAF Advisors Inc. in Minneapolis.

Bernanke, 54, will give fresh clues to the Fed's thinking today in a speech in Washington. Goldman Sachs Group Inc., JPMorgan Chase & Co. and Barclays Capital Inc. are all predicting a reduction in the main rate to 3.75 percent this month, largely because the U.S. jobless rate jumped to 5 percent in December from 4.7 percent in November.

The word ``recession'' is increasingly rolling off the tongues of prominent economists: Goldman, Merrill Lynch & Co. and Morgan Stanley are among large banks whose research teams are predicting an end to the U.S. expansion, now in its seventh year. At the same time, crude oil is trading near $100 a barrel and inflation is above the comfort level of many Fed officials.

Overcoming Reluctance

While some Fed officials may be reluctant to approve such a move, they would ``happily'' vote for it if they were convinced a recession was imminent, said Bank of America Corp. economist Peter Kretzmer, a former Fed staffer who this week predicted an even chance of a half-point or quarter-point rate cut on Jan. 30.

``They don't want to be backed into a corner by the markets,' said Stephen Cecchetti, a professor at Brandeis University in Waltham, Massachusetts, and former head of research at the Fed's New York branch. At the same time, ``why do something that's halfway? You want to make sure that consumer and business confidence doesn't tank.''

The last time Bernanke spoke, the Fed used the speech to signal a change in the central bank's views, Vice Chairman Donald Kohn said last week.

Bernanke said Nov. 29 that market ``turbulence'' had ``importantly affected'' the economic outlook. He declined to repeat the Federal Open Market Committee's October statement that inflation and growth risks were about equal.

Script Changes

The Fed then cut rates on Dec. 11, replacing its ``balance of risks'' with a line saying ``uncertainty'' had increased. Minutes of the meeting showed that Fed officials said economic growth in 2008 would fall short of their own forecasts, reflecting weaker consumer spending and a deeper housing slump.

Since the Fed met Dec. 11, reports have indicated a rising threat of recession. The unemployment rate rose 0.3 percentage point in December, a magnitude that has historically augured economic contractions. The Institute of Supply Management said Jan. 2 its index of manufacturing fell to the lowest level since April 2003.

The reports spurred traders to bet on deeper rate cuts. Futures prices indicate a 78 percent chance of a half-point move, with 100 percent odds of at least a quarter-point reduction.

``Additional evidence of a weaker economy makes a stronger case to take bolder actions than they have so far,'' said David Resler, chief economist at Nomura Securities International Inc. in New York. He forecasts a 3.5 percent federal funds rate by the end of March. ``Conditions have changed more than the Fed may have expected.''

Risks to Growth

Four Fed officials so far this week flagged risks to economic growth, without directly indicating their preference for this month's rate decision.

Prospects of a recession might not be the only problem for the Fed. When officials come to the next meeting on Jan. 29-30 with revised forecasts, the second iteration of the Fed's expanded quarterly economic projections, they will lack some key tools, said Henry Kaufman, the former chief economist at Salomon Brothers Inc. who is now president of Henry Kaufman & Co. in New York.

Instead, the Fed should provide an ``assessment of developments for the next three years'' as well as the change in interest rates required to achieve economic goals, Kaufman wrote Jan. 3 in the Wall Street Journal.

``The Fed would have keener insight as to what's going on in the financial markets and in financial institutions,'' Kaufman said in an interview. ``Eventually that would bring back a somewhat more stable environment, rather than a volatile environment which we've had up to now.''

Central bankers rejected one of Kaufman's proposals as part of their communications review last year that ended in the decision to expand forecasts. Fed officials decided not to report members' assumptions of the ``appropriate'' path of interest rates because of concern that investors would ``infer more of a commitment to following the implied path than would be appropriate for good policy,'' Kohn said Jan. 5.