Fed's Bernanke faces his first big financial test

Turmoil in financial markets amid deepening concern about a credit squeeze is leading investors increasingly to expect the Federal Reserve to cut interest rates. But many economists question if the central bank will — and should — act.

Some economists, such as Maria Fiorini Ramirez, who runs her own economic consulting firm in New York, say the Fed should cut rates to help restore confidence in a financial system quivering amid the subprime mortgage mess.

"In times of crisis, you need someone to stand up and say, … 'We'll do what is needed,' " she says.

But others argue that the problems in the financial markets are not spilling over into the broad economy. And with Fed Chairman Ben Bernanke and his colleagues continuing to focus on bringing down inflation, a rate cut now doesn't make sense, they argue.

"We have a good, healthy economy," First Trust Advisors chief economist Brian Wesbury says. "One portion of it, and it is a relatively small portion, is having trouble."

The distress in the financial markets is the first big test for Bernanke since he became Fed chairman in early 2006.

Bernanke appears to be taking a page from former Fed chairman Alan Greenspan's playbook. The Fed is aggressively adding money to the financial system, and on Friday it put out a rare statement to draw attention to what it was doing. The Fed under Greenspan put out similar statements aimed at easing investors' nerves following the Sept. 11, 2001, terrorist attacks and the stock market crash in October 1987.

The Fed pumped $38 billion into the banking system Friday, the largest since after the Sept. 11 attacks.

But the Fed has maintained its key short-term interest rate target of 5.25% as it has flooded the markets with money. After meeting Tuesday, Fed officials suggested they had no plans to change rates soon, arguing in their statement that while the dangers to the economy had risen it was still expected to grow at a "moderate pace" in the near future.

But investors in a market in which participants bet on future Fed moves are fully banking on the Fed cutting rates by a quarter-percentage point by the end of September. Before the market swoon, the odds were 1-4, according to Moody's Economy.com.

"The markets now seem to be demanding a cut," Lehman Bros. senior economist John Shin says.

One or two rate cuts would foster slightly lower borrowing costs, but may not be enough to help the people who are having problems, Wesbury says. It wouldn't allow the person who bought a subprime, adjustable-rate mortgage that is resetting to double-digit rates refinance to a low, fixed-rate mortgage.

And there could be risks. If the economy picks up speed, inflationary pressures could build. That would force the Fed to turn around and raise rates.

Cutting rates "would be a potentially short-term fix that would create long-term problems," Bear Stearns senior economist Conrad DeQuadros says.

And, as Carl Tannenbaum, chief economist at LaSalle Bank, wrote to clients Friday, "The Fed does not want to be seen as bailing out those who took too much risk, which might encourage that kind of behavior again in the future."

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