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How deep should Fed cut?

Political pressure is on after stock market plummets

The Federal Reserve will meet Tuesday to decide how much to cut interest rates in an effort to revive the economy just when a falling stock market seems to have the power to bring on a recession.

No one doubts that Alan Greenspan, the Fed's chairman, and his fellow policymakers will reduce the federal funds rate from its current level of 5.5 percent when they gather in Washington. The question is whether it will be a big enough rate cut to keep the 10-year-old expansion rolling.

Democratic and Republican lawmakers ratcheted up the pressure on the Fed over the weekend.

"People's confidence is shaken. Their ability to plan housing and automobiles, their savings, their retirements, are altered," Sen. Robert Torricelli, D-N.J., said Sunday, after a week in which the Dow Jones industrial average declined a worst-ever 821.21 points.

"It would be inconceivable to me if the Federal Reserve did not respond this week by lowering interest rates," he told "Fox News Sunday." "It would be outrageous. And I trust the Fed has that message."

Meanwhile, President Bush kicked off a busy week of foreign policy get-togethers by meeting with Japanese Prime Minister Yoshiro Mori.

Monday's two-hour meeting, including a working lunch, carried a full agenda, with discussion on the decline in securities markets worldwide, North Korea and the sinking of a Japanese trawler by a U.S. submarine.

Mori said Monday that he believed a credit-easing measure by the Bank of Japan will have a "positive effect" on the flagging Japanese economy.

He also said he hoped the United States would take "appropriate macroeconomic policies to deal with a U.S. economy that is slowing down."

Attention in Japan, however, was focused on Mori's successor. He is widely expected to step down next month over gaffes and scandals that have sent his popularity plunging to less than 10 percent.

After Monday's session, Bush has meetings lined up with Israeli Prime Minister Ariel Sharon on Tuesday, Chinese Vice Premier Qian Qichen on Thursday and U.N. Secretary-General Kofi Annan on Friday.

Many on Wall Street are lobbying for a cut of three-quarters of a percentage point, or even more, to stop the sell-off of stocks. But other experts argue that a half-point cut is enough for an economy that, apart from the market, still has considerable strengths.

"What I am concerned about is that we are heading into the unknown because of the stock market," said Ian Shepherdson, chief domestic economist at High Frequency Economics, who favors a reduction of three-quarters of a percentage point. "We have never had so big a decline in stock prices at a time when they were so widely held."

The debate over how far the Fed should go to reduce short-term interest rates — thus influencing what lenders charge for mortgages, home equity loans and other credit — reflects sharply different views of the stock market's impact on the economy.

The Fed's policymakers, including Greenspan, have soft-pedaled this impact. They have repeatedly stated that their goal is to target the real economy, asking themselves what must be done to increase lackluster consumer spending, work down a backlog of unsold cars as well as other goods, keep up home sales by reducing mortgage rates and the like. The stock market, in this view, is just one ingredient in the mix.

But Tuesday's meeting will come after a week of plunging stock prices. And many are urging Fed policymakers to recognize that the economy now dances to the stock market, not the other way around.

One important difference, they say, is that nearly 50 percent of American households now own stock, up from less than 10 percent in the early 1960s. And equities, at least until the recent plunge in the market, have become the most important single source of wealth in the country.

"The Federal Reserve has not been able to cope with this changing structure," said Henry Kaufman, the bearish Wall Street economist and consultant. He asserts that, among other shortcomings, the Fed has failed to incorporate into its interest rate policy the extent to which spending and borrowing respond to shifts in a family's stock portfolio. He wants a full percentage-point cut, perhaps enough in his view to end the stock market slide and the damage it is doing to the economy.

Such thinking, however, is widely challenged in academia, where the stock market's movements are often viewed as a less important influence on the economy than factors like the level of unemployment, the value of homes and the pace of wage gains.

"We take the view that the Fed should keep its eye on the inflation ball," said Ben S. Bernanke, a Princeton economist whose research has sometimes been funded by the Fed. "The stock market is relevant to the extent that fluctuations in stock prices affect the inflation forecast."

The markets were mixed Monday, with the Dow industrials up 38 points at 9,860 at 2 p.m. EST. The Standard & Poor's 500 index was off 3.38 at 1,153.17, and the NASDAQ was off 8.26 at 1,882.65.

Greenspan is clearly focused on the real economy, not the stock market. In his last congressional testimony, on Feb. 28, he concluded that "the sources of long-term strength in the economy remain in place."

That is certainly the case for home prices, which have continued to rise on average. And for most Americans, homes represent a bigger investment than stocks. Partly because the Fed has cut rates by a full percentage point since Jan. 3, the average interest rate on a 30-year mortgage has edged down to 6.96 percent from 7.38 percent in December.

What troubles the economy, Greenspan said, are the excesses — too much inventory, for example, and too much production capacity — that "built up in 1999 and early 2000." These excesses, in turn, "engendered a retrenchment that has yet to run its full course."

A joint statement issued after Monday's U.S.-Japan meeting said that the two leaders agreed on the importance of promoting deregulation, structural reforms and direct foreign investment. Bush reaffirmed the importance of taking appropriate policies to support continued growth in the U.S. economy.

Bush and Mori also agreed to cooperate to seek a new framework to strengthen U.S.-Japan dialogue on economic and trade issues. They also agreed to cooperate closely to start a new round of World Trade Organization talks this year, the statement said.

Contributing: Reuters News Service