Why the Fed May Surprise The Markets Next Week

Some economists say its time for Fed Chairman Ben Bernake to just say no to Wall Street and cut interest rates less than the half point that's widely expected at next week's meeting.

Though the financial crisis still weighs heavily on the economy, they argue that conditions have stabilized since the central bank twice cut interest rates by half a percentage point in October. The Fed also has made aggressive and innovative moves to create liquidity that have had a faster and more effective impact on the market and the economy.

Moreover, interest rates—from Libor and short-term Treasury notes to mortgages—have already declined, in some cases, significantly, following recent developments at the central bank.

“I think at most we'll get 25 basis points,” predicts veteran Fed watcher David Jones, who now runs his own consulting firm, DMJ advisors. “You just don't get that much mileage from conventional rate cuts."

Bernanke's recent comments, as well as new measures ready to be implemented or under consideration, show he already knows that.

In a Dec. 1 speech, Bernanke said: “Although further reductions from the current federal funds target rate of one percent are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited.” He added: “The second arrow in the Federal Reserve's quiver—the provision of liquidity— remains effective.”

A week before that, on Nov. 25, Bernanke announced that the Fed would buy some $600 billion in GSE direct obligation bonds and mortgage-backed securities.

Jones calls that “a major policy move that will create confidence and have a major impact,” an assessment shared by other economists as well ass mortgage industry professionals.

Mortgage Rates Plunge

Mortgage rates fell sharply the day of the announcement, mortgage application activity surged in the week thereafter and the rate on a 30-year fixed mortgage is still below 6-percent, which has rarely been the case this year.

“I think rates are on the way down,” says Marc Savitt, President of the national association of Mortgage Brokers, who runs the Mortgage Center in West Virginia. “Even if they stay where they are now, its still a very possible range.”

Perhaps emboldened by that chain of events, Bernanke, also said in his Dec. 1 speech that the Fed could use its balance sheet to ”influence financial conditions," to compensate for banks reluctance to lend, especially at more attractive rates. That reluctance has frustrated the Fed chairman, many members of Congress and—to a lesser extent—Treasury Secretary Henry Paulson.

“The Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities,” Benanke said in that speech. “This approach might influence the yields on these securities, thus helping to spur aggregate demand.”

“I anticipate additional efforts to bring down other rates, such as mortgage rates, while continuing to flood the financial markets with liquidity,” says independent bank analyst Bert Ely.

Fed watchers also say Bernake has run into increasing resistance from some regional bank presidents and voting members of its policy arm, the Federal Open Market Committee, who are wary about taking rates below the historical low of one percent, a level last seen during 2003-2004 when the Fed was concerned about the possibility of deflation.

St. Louis Fed President James Bullard, a non-voting member of the FOMC, is one such dissenter.

“I have not been a fan of going to really low levels," said Bullard, a day after Bernanke’s speech. "In the 2001-2003 episode we went all the way down to one percent. Some have said that that created problems. So I think those two episodes: stopped at three, stopped at one. Why not stop at one this time? Why is it zero this time? I don't quite get that," he said.

Zero rates inevitably draw negative comparisons to the Bank of Japan’s failed policy efforts in the 1990s, when it was trying to revive an economy reeling from a somewhat similar real estate bubble.

Wall Street Not Sold

Though Bernanke and some others in the Fed may be convinced, Wall Street appears unsold on the merits of the argument, which may be one reason why the FOMC delivers a half a percent cut.

“I think the Street is taking a while to catch on and is lost in the symbolism of conventional Fed easing,” says Jones.

“No one seems to have the courage to say this is not the right solution,” says Ram Bhagavatula, managing director at the hedge fund Combinatorics Capital. “They will do 50 basis points because the market wants it.”

Some economists say the December meeting is an opportunity to send a message to the markets and to do the unexpected.

“One of the things [former Fed Chairman Alan] Greenspan did do now and then was go against the markets and surprise everybody,” says Peter Navarro, of the Paul Merage School of Business at the University of California at Irvine. “It would nice to see Bernanke do that, like now.”

The most recent and telling example of that was probably June 2001. The market wanted a half point reduction from the Fed, but the central bank cut by only a quarter, taking rates to one percent, notes Bank of Tokyo-Mitsubishi economist Chris Rupkey.

Rupkey, however, says given the market expectations and the recent plunge in payrolls, it would be “unprecedented” for the Fed not to cut by half a point next week, even if he doesn’t think it’s the right course.

Difficult Exit Strategy

“I think the less they do the better at this stage,” he says. “The exit strategy from a very low level is difficult.”

Some say its premature to worry about how easily the Fed will be able to start raising rates when the time comes, given the combination of a one-of-kind credit crunch and a worse-than-average cyclical downturn.

“You put as much out there as possible and hope it accomplishes the objective,” says David Resler, chief economist at Nomura International, who thinks the Fed will cut half a point next week in taking rates to zero.

Though Resler acknowledges the “interest rate target is no longer a very important gauge of what the Fed is about,” it remains troubled by the fact that the market continues to keep fed funds well below its target rate.

The fact that the Fed decided to turn a one-day policy meeting into the less common two-day one “to allow additional time for discussion, as it’s Nov. 20 news release simply states, is one more reason to think the Fed may be at a turning point, given its extraordinary undertakings as well as staggering the amount of money it has thrown at the financial crisis.

“They want to talk about what they're doing,” says Rupkey. “The public seems to be clamoring for better communication, saying ‘Tell us what you're doing?’”

For Jones, the future course is clear. It means de-emphasizing conventional rate cuts and going directly to the sectors most affected and picking up the slack of the banking system.

“You’re sort of doing it under the radar,” he explains. “And not looking like you're running out of room.”For more stories from CNBC, go to cnbc.com.

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