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With key rate at 1%, speculators bet Fed cuts more

October 31, 2008|Tom Petruno | Petruno is a Times staff writer.

Just a day after the Federal Reserve dropped its key short-term interest rate to 1% -- matching the generational low reached in 2003-04 -- the betting is intensifying on another cut.

Trading on Thursday in futures contracts on the federal funds rate, the Fed's benchmark, implied a 55.3% probability that the central bank would slash the rate to 0.5% on or before its next meeting Dec. 16, according to Bloomberg News data.

On Wednesday, the implied probability of a cut to 0.5% was 32%.

At a minimum, the futures market expects the Fed to take its rate down to 0.75% on Dec. 16.

Rate expectations may reflect the government's report Thursday that the economy shrank at an annualized rate of 0.3% in the third quarter. Although analysts had figured the economy contracted in the period, the details were ugly -- particularly a 3.1% rate of decline in real consumer spending, the biggest drop since the vicious recession that began in 1980.

There are psychological reasons the Fed would prefer not to cut its benchmark rate below 1%. The closer the Fed gets to zero, the more likely investors are to worry that the U.S. economy is facing a long period of misery on par with Japan's experience after its real estate markets crashed in the early 1990s.

The Bank of Japan had to maintain its benchmark interest rate at or near zero for most of the period from 1999 through 2006, before policymakers finally felt comfortable that the economy was in a sustainable recovery.

The wording of the Fed's statement Wednesday suggested that "they may [cut] again if necessary but are probably hoping that they will not have to take the zero option on rates," said Christopher Rupkey, economist at Bank of Tokyo-Mitsubishi in New York.

Others see further cuts as inevitable. "I think the Fed is going lower," said Tom Higgins, chief economist at investment firm Payden & Rygel in Los Angeles. "Zero is the floor."

Given the severity of the credit crunch and its dismal effect on the economy, he said, the Fed's attitude can only be "Why not throw everything at it?"

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tom.petruno@latimes.com

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latimes.com

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