US Economy's Latest Ditty: The Worst Is Yet To Come?

Source : The Business Times, September 25, 2007

IT'S not clear whether the cheerful investors on Wall Street who were celebrating last Tuesday's decision by the Federal Reserve Board's monetary policy committee to slash federal funds rates by half a percentage point were paying much attention to Thursday's Congressional testimony by the US Federal Reserve chairman Ben Bernanke when he seemed to be warning that sub-prime defaults could actually surge in coming months.

But the financial markets as well as US President George Bush were in such a great mood - 'I'm optimistic about our economy. Inflation is down, job markets are steady and strong,' said Mr Bush - that the continuing credit crunch, rising energy prices and a decline in some key economic indicators were having no effect on exuberant investors who pushed the Dow Jones Industrials Average and the broader S&P index to new highs.

Yes, just like in the good old days of former Fed Chairman Alan Greenspan. Mr Greenspan incidentally was appearing on numerous television news shows and book parties trying to sell his memoirs The Age of Turbulence as his successor was addressing lawmakers on Capitol Hill where he promised to use the Fed's regulatory powers 'to address potentially deceptive mortgage loan advertisements and to require lenders to provide mortgage disclosures more quickly'.

During his congressional testimony two days after reducing the federal funds rate from 5.25 per cent to 4.75 per cent, Mr Bernanke reiterated that the Fed's main goal - cutting rates was not to bail out reckless investors but to contain the threat of an economic recession that seemed evident after new data indicated that US employment had declined in August.

'The turbulence originated in concerns about sub-prime mortgages, but the resulting global financial losses have far exceeded even the most pessimistic estimates of the credit losses on these loans,' Mr Bernanke explained to the lawmakers, using dry economic jargon to highlight the potential for an economic crash that could have resulted from the crisis in the housing market and the ensuing credit crunch.

Of course, it would be difficult to show that the Fed's interest cuts last week ended up averting a wider economic crisis. But no one doubts that if anxiety returns to the financial markets in the coming week, critics will blame Mr Bernanke for providing incentives to irresponsible investors to take more risks - the so-called 'moral hazard' problem. And if inflation rears its ugly head soon, the dramatic cut in rates by the Fed will be held responsible for the mess.

In addition to rising oil prices and labour costs, inflation hawks who had opposed the rate cuts are also pointing to the rise in long-term interest rates and in the value of gold, two important indicators of inflation.

At the same time, they argue that there are no signs of an economic recession in the retail and manufacturing sectors and that the earlier warnings about unemployment were overblown.

Moreover, lower rates have helped to push down the US dollar against other major currencies, including the euro, which is, in turn, making imports more expensive and increases pricing pressures and inflation pressures.

At the same time, the fall in the value of the US dollar is also helping to increase US exports which is clearly good news for the American economy by helping the growth of many US industries and creating conditions for a reduction in the huge trade deficit.

From that perspective, the rate cut could prove to be just the kind of stimulus that a somewhat soft US economy needed. But fears of inflation cannot be discounted, especially when one takes into consideration that the rate cuts by Mr Greenspan's Fed were made at a time when the globalisation process helped counter the inflationary pressures of those rate cuts.

That is not the case today. This makes the rate cut by Mr Bernanke's Fed more risky. And when it comes to some of the most serious structural problems facing the US economy - the massive current-account deficit and the accumulating debt by households and businesses - the prospect of Mr Bernanke showering cheap money on the American economy - is certainly not going to help.

It could make things worse by encouraging financial institutions to come up with new ways to extend credit, take more new risks and ignite new financial crises.