BNP strategist: Room for Fed rate cuts

By Ros Krasny

NEW YORK (Reuters) - A second round of pain on the fallout from rising mortgage interest rates means the Federal Reserve could still cut benchmark rates later this year, an interest rate strategist with BNP Paribas said on Tuesday.

But the focus in 2008 could shift more to global inflation and the possible need for the Fed to tighten again, BNP senior bond strategist Richard Gilhooly said at the Reuters Investment Summit in New York.

"We think, effectively, over the next three to six months the Fed will have a window to lower rates if they need to," he said.

Fed rhetoric seems to have been laying the groundwork for a possible shift, even while financial markets have spent the past month or more taking out all the implied easing for 2007, Gilhooly said.

"I think the Fed thinks that we haven't seen the worst of subprime ... the Fed is indicating that that housing market will continue to be a problem," he said. "It's clear the (Federal Open Market Committee) statements have become more balanced."

The U.S. central bank has kept its benchmark overnight lending rate at 5.25 percent since June 2006. Financial markets currently show little chance of a rate cut between now and year-end. As recently as late April, rate futures priced in between one and two quarter-point Fed eases.

"At this point we've taken out the Fed eases but don't have enough data or Fedspeak to start to price in tightening," Gilhooly said.

The analyst said the impact on consumers as adjustable-rate mortgage reset at higher interest rates, following on the heels of the crisis in the subprime mortgage market, "has not happened yet. But later this year the Fed will, if anything, have a little room to cut rates."

Many three-year ARMS from 2004 will reset to the 6-1/2 to 6-3/4 percent area from the 4 percent range, he said.

Gilhooly said the case for a Fed ease would be bolstered if the core personal consumption expenditures (PCE) index dropped toward a year-over-year 1.8 percent in the next three months from April's 2.0 percent.

The potential for a 1.8 percent reading before long is "a pretty reasonable supposition. Core PCE has fallen more than people expected," he said.

A number of Fed officials have cited 1 percent to 2 percent on the core PCE as their "comfort zone" on inflation, although the bank does not use an official target.

For 2008 Gilhooly said the Fed policy outlook could be biased more toward rate hikes created by higher global inflation and rising commodities prices.

Inflation expectations, as shown by the spread between Treasury inflation protected securities (TIPS) and Treasury yields, have barely budged during the current bond-market sell-off.

But a flare-up in those expectations, which are watched closely by policy-makers, remains a risk, Gilhooly said.  Continued...