Will the Fed Cut Rates Next Week?

Our bias had been that the Fed will do nothing until next year, just holding rates steady and tossing the markets an occasional jawbone.

But there is a good case to be made for a 25 basis point rate cut when the Fed meets next week on Tuesday 16 September. We now make the odds 55-45 for a cut.

How come?

The Fed has been given a short term gift by the dollar rally and commodities smackdown. Whatever the actual inflation rate may be, and we think its much higher than the official statistics allow, the perception is that inflation is waning because of the price drops in materials, especially oil. So they have more latitude for a cut than they had say in early July when all this started. And the bonds have rallied comfortably. A much stronger dollar is going to start dampening exports, which is the only thing the real economy has going for it lately.

There is a strong case to be made that the economic outlook has worsened in the jobs reports and unemployment levels. The credit crisis is also becoming more of a problem for the non-marquee financial names. The Fed needs to steepen the rate curve and a lower short end would be a little extra vigorish for the boys.

Lastly, this is probably the last chance the Fed will have to cut this year with a comfortable margin ahead of the November elections. The October meeting is just about a week beforehand and the Fed will be sensitive to accusations of political favoritism, especially if the polls are close. The Fed is many things, and among them it is a self-perpetuating bureaucracy.

The Fed and Treasury have been heavily targeting their liquidity adds to financial institutions with insolvency problems because of illiquid debt. The problem is that the write offs are coming too slowly because of a preoccupation with bonuses and stock prices, so the 'trickle down' to the real economy is not happening and credit flows are seizing again. A rate cut will be viewed as relief for the whole economy and not just the elites of the Street.

The case against a rate cut is twofold. First, there could be some concern about scaring the markets. We think a 25 bp cut spun as a "one and done" for 2008 is no problem there.

The other negative is a little more pointed. A stronger dollar encourages inflows of financial investments, which could be a factor in the desire of Wall Street banks to recapitalize. The Fed would probably like to keep the dollar away from that breakdown level it was bouncing along earlier this year.

The question now is how resilient will the dollar be? Can it hold its rally? Can the Fed cut rates and maintain the illusion that the US will be coming out of its problems first among developed nations? The answer here is similar to the first difficulty. The spun "one and done" can work to dampen fears for the dollar as well as the equity markets.

So there it is. Let's see what happens with Lehman over the weekend and the FOMC decision on Tuesday.