Monday, September 17, 2007

Fed Faces Tough Call On Rates As Recession Fears Mount

Source : Channel NewsAsia, 17 September 2007

WASHINGTON : Federal Reserve policymakers face tough choices as they debate interest rates amid rising recession risks, but also concerns about inflation and a "bailout" of real estate speculators, analysts say.

The Federal Open Market Committee, which meets Tuesday, is widely expected to act in the face of the worst housing slump in decades, which has led to rising mortgage defaults and a tightening of credit standards that threatens the overall economy.

A growing number of analysts say they expect the FOMC, which has held its federal funds rate at 5.25 percent since June 2006, to cut the benchmark rate by 25 or 50 basis points.

Of key importance is the message sent to financial markets.

Chairman Ben Bernanke wants to ease economic stress while averting a return to easy money conditions that, according to some critics, fuelled the real estate boom-bust cycle.

"The Fed does not want to cut the fed funds rate, but it may well be forced to because of the inevitable slowdown in US economic activity arising from the sub-prime-induced credit crunch," says Sherry Cooper, chief economist at BMO Nesbitt Burns in a note to clients.

"But Ben Bernanke has made it very clear that he will not bail out imprudent lenders and investors (read 'hedge funds') by aggressively easing monetary policy."

Cooper says the most likely scenario is for the Fed to cut by 25 basis points and wait to see if credit conditions return to normal.

She says other actions - such as injecting liquidity into markets and easing conditions for the Fed's discount window - may continue or intensify.

Joseph Balestrino, analyst at Federated Investors, agrees that the Fed is likely to use an "incremental" approach but that more rate cuts may follow in the coming months.

"Over the near-term, as adjustable-rate mortgages reset, defaults and foreclosures are likely to rise," he said.

"This should generate still more daunting headlines, keeping markets on edge. That also should keep the Fed in the game, signalling its readiness to act as necessary to keep the economy on track. This probably means a series of additional quarter-point rate cuts."

Economists continue to downgrade their forecasts amid weak economic data.

One report showed the US economy lost 4,000 jobs in August in the first labour market contraction in four years.

A slowing of job creation is likely to dent consumer spending, the main driver of economic activity.

The UCLA Anderson School of Business, in its most recent report, said current conditions represent "a near recession experience," with growth holding around one percent for the fourth quarter of 2007 and early 2008, with a return to normal growth of around 3.0 percent delayed until 2009.

Financial markets are effectively pricing in a rate cut of 25 basis points and some traders are expecting more. Ironically, some analysts say the Fed may want to show it is not yielding to market pressure.

"The nearly universal belief that the Fed will cut rates next week is a little worrisome since there still is a viable argument for the FOMC to hold rates where they are," said Gregory Drahuschak at Janney Montgomery Scott.

He said it remains unclear "whether the market will view whatever the Fed does as being enough. A quarter-point cut, for example, might be viewed as not being enough.

A 50 basis-point cut might be viewed as a panic reaction."

Economist Diane Swonk at Mesirow Financial said that with housing woes deepening, Bernanke and his colleagues will not want to risk pushing the economy into a prolonged recession.

"Bernanke is ultimately as risk hedger, which means that he would rather overstimulate the economy than risk a recession by not acting at all," Swonk said.

"Remember, this is the same man who in 2003 reassured markets that he would drop money from helicopters if necessary, to avoid deflation." - AFP/ch

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