Recession Unlikely But Concerns Could Spread: Bush's Ex-Adviser

Source : The Business Times, January 24, 2008

The US Federal Reserve's surprise 75 basis point cut in the Fed Funds rate on Tuesday 'was certainly the right thing to do' and 'more action is warranted', but the US economy is unlikely to fall into recession, according to the former chairman of President George W Bush's Council of Economic Advisors.

Glenn Hubbard, who is currently dean of Columbia University's business school and also holds a chair in economics, added however that it might be a few months before financial markets settle down. He maintained that the effect of the Fed's rate cut on the US dollar would not necessarily be negative.

In an interview with BT, Mr Hubbard said that a US recession was unlikely. 'A literal recession is what the National Bureau of Economic Research says it is, but normally they look at labour market deterioration, they look at unemployment insurance claims data - and those don't look anything like a recession,' he pointed out. 'We have slowdowns in hiring, but nothing like what you'd see in a recession. I think it's unlikely, particularly because of the lagged effects of the monetary accommodation we've had already. Given all that, I would expect the Fed to do a little bit more, but not a lot.'

The Fed's rate cut would, he said, help financial institutions by steepening the yield curve.

A steeper yield curve implies a greater differential between short-term rates and longer-term rates. This typically benefits banks which can make bigger spreads by borrowing, or taking deposits, at lower short-term rates and lending at higher longer-term rates.

Mr Hubbard cautioned however that although the Fed can help improve liquidity, it cannot make good the capital shortfalls faced by many financial institutions. And it's the uncertainties surrounding this issue that worries investors. 'That's what's alarming people,' he said. 'We don't really know where all the problems lie, so we think of really outsized losses, like the losses at Citi and Merrill, Bank of America, Wachovia Bank and Bank of China. Market participants are wondering how many more shoes are going to drop.'

He added that it could be a few months till the financial markets settle down. 'I think it'll be a while, well into the spring, because people will be looking at not just this round of earnings, but the next quarterly earnings to see how many additional write-offs there'll be,' he said.

He also pointed to the possibility of contagion to other areas. 'There's concern about other businesses. Everything's been focused on sub-prime so far, but Citi's news about credit cards raises other concerns. How big is this? We don't know. So, until that becomes clear, there'll be a big weight on the financial sector stocks.'

A week ago, Citigroup announced net credit losses of US$1.56 billion largely due to credit-card operations.

Mr Hubbard, who now serves as economic adviser to Republican presidential candidate Mitt Romney, said that rate cuts by the Fed are not necessarily negative for the US dollar. 'There are multiple determinants of the value of the dollar,' he pointed out. 'The interest rate differential is one, but there's also the health of the US economy. If you think that the Fed's action was important for avoiding a recession, then it's not obvious that it would be a significant negative for the dollar. And other major central banks may well follow suit.'