Fed Interest-Rate Cuts Fail to Lower Borrowing Costs (Update3)

By Scott Lanman

Feb. 13 (Bloomberg) -- The Federal Reserve's interest-rate cuts last month have failed to lower borrowing costs for many companies and households, increasing the chance of further reductions from the central bank.

Companies are paying more to borrow now than before the Fed reduced its benchmark rate by 1.25 percentage point over nine days in January, based on data compiled by Merrill Lynch & Co. Rates on so-called jumbo mortgages, those above $417,000, have increased in the past month, making it tougher to sell properties and risking further price declines.

``It's the clogging up of the credit markets that worries me most,'' Harvard University economist Martin Feldstein said in an interview in New York. ``The Fed has done a lot of cutting, the question is whether it's going to get the traction that it did in the past.''

Lenders and investors are demanding greater compensation for offering credit as losses mount on subprime-mortgage securities and concerns grow that ratings of bond insurers will be cut. Elevated borrowing costs mean Fed Chairman Ben S. Bernanke will have to reduce rates further to revive the economy, Fed watchers said.

Banks have been forced to abandon loan sales or offer discounts of as much as 5 percent for companies including Harrah's Entertainment Inc., First Data Corp. and Alltel Corp. in the past six months because of investor reluctance to buy debt perceived to be too risky.

Delphi Financing

General Motors Corp., the world's largest automaker, said yesterday it may have to help its former auto-parts unit, Delphi Corp., obtain $6.1 billion in financing to emerge from two years of bankruptcy because of ``difficulty'' in finding investors for the loans Delphi needs.

``The problem is that every piece of news we're getting continues to be bad,'' said Stephen Cecchetti, a former New York Fed bank research director, and now a professor at Brandeis University in Waltham, Massachusetts. ``They will have to ease more. It's the only thing they can do.''

Feldstein, who heads the National Bureau of Economic Research, the group that sets the dates for U.S. economic cycles, said the chance of a recession is ``close to 50-50.''

Traders now see a 100 percent chance of at least a half- point reduction at or before the Federal Open Market Committee's March 18 meeting, up from 68 percent on Jan. 31, when the Fed cited tighter credit conditions as a reason for lowering rates. Futures show 20 percent odds of a three-quarter point move.

Retail Sales

Futures rallied even after a government report today showed retail sales rose 0.3 percent in January from December, against the median forecast in a Bloomberg News survey for a decline. Economists said the gain, led by car and gasoline purchases, wasn't enough to indicate Fed rate cuts are affecting spending.

Bernanke may give an update of his outlook tomorrow when he testifies before the Senate Banking Committee at a hearing on the economy and financial markets. Treasury Secretary Henry Paulson and Securities and Exchange Commission Chairman Christopher Cox are also scheduled to appear.

The extra yield investors demand to buy investment-grade U.S. corporate bonds rose to 2.37 percentage point Feb. 12 from 2.24 percentage point on Jan. 21, Merrill data show. For high- risk, high-yield securities, premiums over Treasury securities have risen a quarter-point, Merrill data show.

Yellen Frustration

``The increase in credit spreads has sort of worked against our policy,'' San Francisco Fed President Janet Yellen told reporters at her bank yesterday. ``The fact that the spreads went up so dramatically really resulted in an effective tightening of financial conditions that our cuts were partly meant to address.''

Those cuts were the fastest since the federal funds rate became the principal policy tool around 1990. The Fed lowered the rate by 75 basis points on Jan. 22 in an emergency move, then by an additional 50 basis points at the regular meeting on Jan. 30. A basis point is 0.01 percentage point.

Beyond March, traders expect quarter-point rate reductions at the following FOMC meetings in April and June, based on futures prices on the Chicago Board of Trade.

In the market where banks lend to each other, borrowing costs have receded since the Fed began special auctions of funds in December. The three-month dollar London Interbank Offered Rate fell to 12 basis points over the Fed's target rate today, from more than 1 percentage point above it two months ago.

`Not Functioning'

Yellen acknowledged in a Feb. 7 speech, repeated yesterday, that borrowers with greater default risk are paying more for loans. The markets for securities backed by mortgages ``are not functioning efficiently, or may not be functioning much at all,'' she said.

``As long as the credit strains remain and might even still be intensifying, it certainly supports the case for continuing to ease aggressively,'' said Brian Sack, a former Fed research manager who is now senior economist at Macroeconomic Advisers LLC in Washington. ``We don't need spreads to come down. We do need them to stop widening.''

The lack of improvement may make a fiscal-stimulus plan passed by Congress last week more critical. The $168 billion package, to be approved by President George W. Bush today, would send tax rebate checks to more than 111 million households, probably beginning in May.

``It's a necessary thing given the uncertainties about both the economy and the power of monetary policy at this point,'' said Harvard's Feldstein. It will probably add 1 percentage point to economic growth, he said.

Fannie, Freddie

The bill will allow Fannie Mae and Freddie Mac to raise the limit on purchasing ``jumbo'' loans to $729,750 from $417,000. The idea is to help struggling homeowners finance larger mortgages at lower interest rates, especially in expensive metropolitan areas such as New York, Washington and Southern California, where median home prices now exceed the $417,000 limit.

Yesterday, at a closed-door luncheon with Republican senators in Washington, Bernanke was ``very upbeat'' that the economy would avoid a recession, Iowa Senator Charles Grassley said in an interview.

Kentucky Senator Jim Bunning said in an interview that while Bernanke didn't comment on interest rates, the Fed chief said that ``they have their eye on inflation and price stability, and if the credit crunch didn't ease, obviously they are going to have to do something about it.''

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net

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