What the Fed is considering at its meeting

The Federal Reserve looks set to deliver a small interest rate cut on Wednesday to help an economy moving sideways at best and could signal the move is the last in a cycle as officials eye inflation warily.

The Fed has already cut interest rates to 2.25 percent from 5.25 percent in six steps since mid-September in an effort to keep U.S. economic activity going in spite of a credit crunch and a deep housing downturn.

Food, fuel and raw material prices are rising, boosting inflationary pressures, a Fed report said recently.

"This meeting's accompanying statement poses a special challenge for the committee justify easing another quarter point to avoid a deeper recession, and simultaneously acknowledging the risk of commodity inflationary pressures," RBS Greenwich Capital analysts David Ader and Ian Lyngen said in a research note.

Interest rate futures prices imply about an 80 percent probability of a further quarter-point reduction and about a one-in-five chance of no move at all when the Fed wraps up a two-day meeting on Wednesday.

The government reports on first-quarter U.S. gross domestic product on Wednesday. Economists polled by Reuters expect the economy expanded at a sickly 0.2 percent annual rate, which would be the weakest since the closing months of 2002.

In addition to cuts in benchmark rates, the U.S. central bank has unleashed a series of emergency measures, sometimes in coordination with other central banks around the world, to keep banks and major financial firms lending and borrowing. In a dramatic intervention last month, it stepped in to prevent the failure of wounded investment bank Bear Stearns .

With some signs financial markets are stabilizing, Fed officials expect the combined effects of rate cuts and a $152 billion government stimulus package to revive the economy.

They are likely to discuss whether borrowing costs are appropriately positioned to aid recovery without fostering inflation. Their statement will provide clues to the tone of that debate.

Following are some factors Fed policy makers will be considering on Tuesday and Wednesday:

LIQUIDITY: Fed officials are worried about continued signs of strains in short-term funding markets, as evidenced by elevated risk premiums institutions are continuing to pay. Elevated spreads between the London Interbank Offered Rate, a gauge of what banks charge each other for loans, and overnight indexed swaps, a measure of anticipated central bank interest rate targets, fuel those concerns.

Policy-makers have offered more than $400 billion in liquidity to banks and primary dealers in Treasury securities, and suggest they are ready to bring more liquidity measures to bear if necessary to restore normal market functioning.

INFLATION: Fed officials are hearing from their contacts around the country that food, fuel and raw material prices are rising and contributing to inflationary pressures, the central bank's Beige Book survey released on March 16 showed.

Also, two members of the Fed's interest-rate setting committee voted against the March decision to cut rates by a sharp three-quarters of a percentage point, preferring less aggressive action and citing the potential for higher inflation -- and higher inflation expectations as a worry.

But other Fed officials believe that higher-than-desirable levels of inflation will not persist as the slowing economy raises unemployment levels.

RECESSION WATCH: The economy is growing sluggishly and possibly even contracting. Of most concern to policy-makers is evidence from measures of confidence that the slowdown is driven by a retrenchment in consumer spending, rather than in business investment.

However, Fed officials' chief concern is that growth could brake more than expected. Gloomy consumer sentiment could feed a sharper slowdown and persistently tight credit could neutralize the effect of Fed rate cuts in providing a boost to economic activity.

Finally, housing markets remain very weak. But policy-makers expect those doldrums to lift over the course of the year and look for housing to exert less of a drag on economic growth in coming quarters.

RECENT COMMENTS:

Dallas Federal Reserve Bank President Richard Fisher, April 22: "It's really a question of, are we getting the bang for the buck (from interest rate cuts). And clearly we're not. The system is sputtering."

Philadelphia Fed President Charles Plosser, April 18: "A slowing economy is no guarantee of slowing inflation pressures. The role of monetary policy is to ensure the stability of the purchasing power of the nation's currency, so that markets are not distorted by inflation. To insure the credibility of monetary policy we should never ask monetary policy to do more than it can do."

Fed Chairman Ben Bernanke, April 2: "Overall, the near-term economic outlook has weakened relative to the projections released by the (Fed) at the end of January. It now appears likely that real gross domestic product will not grow much, if at all, over the first half of 2008 and could even contract slightly.

"We expect economic activity to strengthen in the second half of the year, in part as the result of stimulative monetary and fiscal policies; and growth is expected to proceed at or a little above its sustainable pace in 2009, bolstered by a stabilization of housing activity, albeit at low levels, and gradually improving financial conditions. However, in light of the recent turbulence in financial markets, the uncertainty attending this forecast is quite high and the risks remain to the downside."

Bank's mail jingles as borrowers walk: James Saft

Increasing numbers of Americans are simply walking away from their houses and mortgages, increasing pressure on banks and the economy.

Rapid house price falls in many parts of the United States will soon leave as many as one in five borrowers owing more on their loan than the house will fetch, removing at a stroke the single most powerful incentive to keep up with payments.

The phenomenon of "walk aways" or "jingle mail," so called because of the noise the house keys make in the envelope mailed to the bank, is hard to measure but shows every sign of gathering pace and having a substantial impact.

Wachovia Corp went so far as to change its models on how quickly loans will go bad in the face of what it called "unprecedented" changes in consumer behavior.

"I don't know where the tipping point is, but somewhere when a borrower crosses the 100 percent loan to value, somewhere north of that their propensity to just default and stop paying their mortgage rises dramatically and really accelerates up. It's almost regardless of how they scored, say, on FICO or other kinds of credit characteristics," Wachovia chief risk officer Don Truslow told analysts on a conference call.

FICO, a credit score developed by Fair Isaac Corp., is one of many barometers of credit worthiness used in home lending to help predict the likelihood that a borrower will repay.

Wachovia this week announced that it would make a $2.8 billion provision for credit losses as it posted a first quarter loss, cut its dividend and sought to raise $7 billion in fresh capital.

While the law varies from state to state, in many parts of the United States mortgage lenders cannot go after defaulting borrowers' other assets. And even where they can, few lenders take the expensive and low-yielding option of chasing down borrowers who walk away from loans.

The scale of the potential problem is huge.

Mark Zandi of Moody's Economy.com estimates that 10.6 million homeowners will have zero or negative equity by the end of June, or 21 percent of first mortgage holders.

The impact of a new wave of defaults will also be potentially important. Banks and other investors in mortgages, as has been seen, will take further hits to their already weakened capital.

While few might shed tears for banks, this means a longer and deeper credit crunch. It will also mean a wave of new properties hitting the real estate market, driving prices lower still, as banks seize and seek to sell the houses homeowners have fled.

To give a flavor of the impact, Zandi has estimated that every foreclosure on a neighborhood block reduces the value of all homes on that block by almost 1.5 percent.

GROWING PHENOMENON

To be fair, not every loan default by someone whose house isn't worth as much as the loan is a walk away, but the two are closely linked. Wachovia is far from alone in feeling the impact from "walk aways."

Regions Financial Corp (RF.N: Quote, Profile, Research), a large U.S. bank active in the southeast, on Tuesday announced that nonperforming assets had nearly tripled to $1.2 billion, driven in part by deterioration in its home equity loan portfolio.

Regions chief executive C. Dowd Ritter gave analysts a similar picture of how borrowers react when confronted with steep drops in home valuations.

"As they started to sell it or refinance, they realized that valuation was 40 percent below what it was that 18-24 months ago and they are walking away from those homes in those markets," he said.

Data from real estate firm RealtyTrac not only shows a rapid rise in overall foreclosures, but also suggests a rising number of walk aways.

Home foreclosure filings surged 57 percent in the 12 months to March and bank repossessions soared 129 percent from a year ago, according to RealtyTrac.

In most of the United States, foreclosures follow a sequence of an initial notice of default, then notice of a scheduled auction, and finally a "REO" filing indicating repossession.

If borrowers walk away, lenders can skip the auction notice and accelerate repossession.

"On a year-over-year basis, default notices were up nearly 57 percent and bank repossessions were up nearly 129 percent, but auction notices were up only 32 percent, indicating that more defaulting homeowners are simply walking away and deeding their properties back to the foreclosing lender," said James J. Saccacio, chief executive officer of RealtyTrac.

While borrowers acting in their own best interests really shouldn't shock anyone, the costs associated will be just another unwelcome drag on the economy and finance until the value of U.S. houses stops falling.