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Saturday March 8, 2008 - 00:30:25 GMT
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FOREX NEWS - FED FOCUS-US "real" interest rates set to go negative

By Ros Krasny

CHICAGO, March 7 (Reuters) - A job creation drought in the United States has almost guaranteed that the Federal Reserve will push benchmark interest rates down to negative real levels this year in an attempt to regenerate economic growth.

More economists are starting to expect the end-point of the Fed's current rate cutting cycle to be under 2.0 percent, perhaps in the 1.5 percent to 1.75 percent range, which may help to keep bond yields at negative real rates of return below the current U.S. inflation rate.

The Federal Open Market Committee meets on March 18 to determine its next move on interest rates. Federal funds, the Fed's key lending rate, now stand at 3.0 percent, after being cut from 5.25 percent last September.

Short-term interest rate futures, which measure market sentiment toward Fed policy, imply that the Fed will lower the funds rate to 2.25 percent this month FFJ8, and probably to 1.75 percent by mid-year.

"Fed funds will go below the rate of inflation this year. The Fed will take that risk. It is dealing with a massive decline in consumer spending and housing," said Len Blum, managing director at Westwood Capital LLC in New York.

Speaking in Rio de Janeiro on Friday, Kansas City Fed President Thomas Hoenig conceded that the Fed's rate moves faced "significant headwinds" in gaining traction against the financial market mess, even though cuts so far have been "significant."

That suggests the Fed might need to lower rates even more than bleak economic data suggests, perhaps into the negative real territory that typically fans inflation.

"You can't make banks lend. You can't push on a string," said Blum, who noted that many current and potential homeowners are having a hard time getting mortgages.

Core inflation, stripped of food and energy costs, is running at an annual 2.2 percent, but Fed forecasts call for a gradual retrenchment over the next few years.

But headline consumer price inflation including food and energy costs is running at a 17 year high over 4.0 percent.

Janet Yellen, San Francisco Fed President, said on Friday that "quite a bit more" slack could emerge in the labor market, likely putting downward pressure on inflation.

In January, Fed officials had a "central tendency" forecast for core PCE inflation to retreat to 1.7 percent to 1.9 percent by 2010 from 2.0 percent to 2.2 percent this year.

That forecast means "a 1.75 percent nominal fed funds makes sense, among other things, for now," said Rudy Narvas, analyst at 4CAST Ltd. in New York.


Negative real interest rates are most likely if growth expectations are particularly low or if uncertainty is particularly high, Harvard economics professor Greg Mankiw wrote on his blog this week.

"Both forces seem to be working now," said Mankiw, a former chairman of the White House Council of Economic Advisors.

In futures, the implied fed funds rate by midyear FFN8 has been hovering just above 1.75 percent, and traded as low as 1.69 percent on Friday following the February nonfarm payrolls report.

The important monthly Labor Department data was the final straw for some economic forecasters, showing a second consecutive month of net job cuts for the first time since May-June 2003.

U.S. payrolls fell by 63,000 in February, the biggest slide in almost five years, heightening fears that the economy has slipped into recession.

Economists at Lehman Brothers now warn of a possible double-dip recession in the first half of 2008 and again in early 2009 once fiscal stimulus measures fade.

"We now believe the tax rebate checks will arrive too late to prevent an outright recession," said Lehman economist Ethan Harris.

"We expect (the Fed) to cut another 150 basis points by early 2009," the Lehman economists said.

That would take nominal fed funds to 1.5 percent, not far from the 1 percent seen from June 2003 to June 2004 -- a time when the Fed faced a deflation, not an inflation, risk.

© Reuters 2008 All rights reserved


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