Friday’s surprise cut to the discount rate by the U.S. Federal Reserve Board could yet lead to a future cut in the Fed funds rate, possibly even an inter-meeting move, say Bay Street economists.

The Fed surprised markets by announcing a 50 basis point cut in its discount rate today, in an effort to cool markets. It also said that it is prepared to take further action to mitigate damage to the economy, if necessary.

“This lowers the cost of capital for banks and helps keep credit flowing through the economy at a time when investors have shown a greater reluctance to lend,” notes BMO Capital Markets, adding, “This action is intended to calm jittery markets, which have sold off sharply since July 19.”

The decision has no impact on the federal funds rate, BMO says, “but given the Fed’s statement regarding downside risk to growth and its promise to act as needed to support economic growth, there is widespread speculation that a cut in the fed funds rate is coming.”

“These Fed actions show that Bernanke, like his predecessor, is willing to temporarily ignore his
inflation objectives to offset a credit crunch. This is important because, until now, Bernanke seemed to shun the so-called `Greenspan put’–the predilection of Alan Greenspan to bail out financial players when markets plunged in a disorderly fashion,” it says. “Noteworthy is the absence of William Poole’s name in the roster of FRB President’s endorsing the discount rate cut. Poole has been outspoken in his view that it would take a “calamity” to cause the Fed to ease monetary policy.”

“The Fed will now do whatever it takes to re-establish financial stability. The worst is now over in financial markets,” BMO concludes.

Global Insight says that, following this move, “A cut in the federal funds rate target to 4.75% is now likely, most probably at the Fed’s September 18 meeting, justified by the downside risks to growth.”

“The initial market reaction to the Fed’s move today was euphoric, and the stock market surged. But that’s not the real test, which will come over the ensuing days and weeks in the stability of the markets and the evidence on the economic fallout,” Global Insight says. “If financial markets settle down, and if there is little evidence of economic fallout, then the Fed will be able to reverse its liquidity actions and keep the target federal funds rate at 5.25%. That scenario looks too optimistic.”

“The likelihood now is that GDP growth will slip below even the modest 2.3% pace that we had anticipated over the next four quarters, dragged lower by another leg down in the housing spiral,” it concludes. “We believe that the Fed will share this view and decide to follow up its liquidity actions with a cut in the target federal funds rate to support economic growth. We should expect to see the target federal funds rate cut by 50 basis points in the near future, most probably at the September 18 meeting.”

TD Bank also says that the discount rate reduction, “strongly signals to markets that the Fed is prepared to ease monetary policy if the credit crunch does not dissipate soon. Since the next fixed policy announcement date is not until September 18th, the implication is that a continuation of liquidity pressures in the coming days would likely prompt an inter-meeting rate cut.”

“The actions by the central banks to provide liquidity are unambiguously positive and should eventually help to shore up confidence. At the moment, we are still not prepared to forecast rate cuts,” TD says. “The central banks are loath to ease because they remember that the U.S. housing bubble and the mis-pricing of risk were partly due to excessively easy monetary policy in the past. They are also still concerned about inflation and they recognize that interest rate cuts would not address the source of the current financial problem. Nevertheless, they will cut if there are signs that the financial turmoil is weighing on the economy, or if they feel that the health of financial system is in jeopardy.”

“The main message is that the economic fundamentals remain solid and the most likely scenario is that the financial problems will pass. History suggests that financial markets invariably overshoot and price in the worst case scenario before sentiment turns. And, while further market losses are possible, the good news is that liquidity events tend to be short-lived,” TD concludes. “In the coming months, there will likely continue to be significant volatility, as markets evaluate the economic fallout and the appropriate risk assessment on various financial assets. There has also been limited economic fallout from past liquidity crunches, so we suspect that shares that have been hard hit by fears of an economic downturn will rebound.”

@page_break@BCA Research also believes that the conditions are in place for a Fed rate cut. “Policymakers do not wish to be seen as bailing out poor investments. Nonetheless, in the end they have no choice if credit markets begin to freeze,” it says. “Unless market liquidity improves in the coming days, the Fed probably will provide an inter-meeting rate cut. The Bank of Canada will likely follow suit, given similar financial strains. The ECB will likely wait to see if Fed action calms the markets.”

National Bank Financial says that the Fed was more than justified to open one more safety valve by cutting the discount rate. “By doing so, the Fed is giving itself more time to assess the situation and see if market calms down. Make no mistake, if this is not enough, the FOMC will follow through with cuts in the Fed funds rate. Our long-held scenario that the Fed would need to cut the target rate before year-end is about to materialize.”