Market Week: Should Fed Tread Lightly on Rates?

WHEN it comes to cutting interest rates, a little may go a long way. As the debate heats up over whether the Federal Reserve will lower rates by a quarter- or half-percentage-point on Tuesday — no cut at all has been all but dropped from consideration — one investment adviser thinks the smaller option is better.

“The Fed is caught between enormous pressure to do something and mostly internally generated pressure not to be seen giving in” to Wall Street interests demanding a big cut, said P. Brett Hammond, chief investment strategist at the New York fund manager TIAA-CREF. One reason that he finds a quarter-point cut more prudent is that if central bankers opt for a half-point move and the markets continue to fare poorly, what do they do for an encore?

“The Fed needs to have some more ammo,” Mr. Hammond said. “We’re not dealing with high interest rates here. The Fed does not want to over-cut.”

The Fed is not expected to cut too too much. While a growing number of investment professionals seem to think that a half-point move is likely, a Bloomberg News poll of economists continues to anticipate a quarter-point reduction in the key federal funds rate, to 5 percent.

Whether that will please the shaky stock market is another story. Mr. Hammond contends that traders would react less favorably to a quarter-point move.

Futures contracts “are pricing in a big drop” in rates in coming months, he said. If that drop does not get off to a rousing start on Tuesday, “the markets could be very disappointed.”

But while stocks could tumble if the Fed makes the smaller cut, Mr. Hammond says only the larger one would spark a small rally. And even if a half-point cut did help the markets on Tuesday, it might prove less beneficial in the long run, in his view, because it would send the wrong message to trading firms whose risk-taking helped land the markets in the mess they have been in lately.

“We all need to be reminded in financial services that when the markets are bad, it doesn’t mean the U.S. economy is bad,” he said. “We’re not the center of the universe.”

DATA WATCH The Fed and the markets may get some good news just before the rate decision on Tuesday. Wholesale prices, excluding food and energy items, are estimated in the Bloomberg poll to have risen by a modest 0.1 percent in August, the same as July. The next day, August core consumer prices are forecast to show a 0.2 percent rise, also matching the July number.

A report on Wednesday on housing market conditions is expected to show more of the weakness to which investors have grown accustomed. Housing starts and building permits are both forecast to have fallen last month.