Can Fed come to the rescue with cuts?


The early days of 2008 are giving sharp-eyed economy-watchers plenty to think about. There’s the manufacturing index, the price of oil, dribs and drabs of data on last month’s retail sales, and naturally there’s more news on the housing market and the state of the lenders, and news of Singapore’s growth.


Perhaps the minutes of the last Federal Reserve meeting provide the most useful food for thought. One theory runs that a huge housing bubble and unsustainable consumer boom in the US has to be corrected, and that the correction will be brutal. These are the critics who have been regarding the ballooning American trade and budget deficits with amazement for several years.


Similarly to the “get real” brigade who had to watch the boom prove their doubts wrong for a few years before the Nasdaq crashed, the guys who believe that severe imbalances only end in tears must reckon that their time is now. The troubles of the big banks and brokers are merely symptoms, in this view, of an unwinding in which Americans must cease to consume more than they produce, even if it takes a very deep economic contraction to get there.


A much more prevalent and optimistic line of thinking points to the success of modern economic management. Monetary authorities have brilliantly avoided any really brutal corrections in the US and Europe for decades. After all, the 2001 recession barely registered for most people and 1991 was not much to write home about, either. The last really nasty disruptions were those suffered by emerging economies, especially those of the Asian tigers, in the late 1990s. The US economy has the special benefit of the dollar being the world’s reserve currency and its major creditors – China and the petro-powers – hold vast dollar reserves whose value they have every interest in maintaining.


That, and the broad diversification of American business, are all supposed to be proof against the kind of financial crisis – with hot money outflows and a sharp loss of asset value and jobs – that the tigers suffered.




So can the Federal Reserve simply ride to the rescue again with much lower interest rates on short-term money? The minutes of their December meeting show that they seem ready to do that if necessary. A key quote that shows how the Fed perceives the risk to the economy and their role in countering it: “Some members noted the risk of an unfavourable feedback loop in which credit market conditions restrained economic growth further, leading to additional tightening of credit; such an adverse development could require a substantial further easing of policy.” The minutes also show that in early December the Fed’s economists saw a slowdown in activity and expected further slowing in early 2008. It helped that the Fed believed that inflation remained reasonably under control, indeed that core inflation would be stable in 2008. Whether that sanguine outlook has changed with the consumer price index report, that appeared after the last Fed meeting, remains to be seen. The November rise of 0.8 per cent in headline inflation and 0.3 per cent in prices excluding energy and food were both pretty bad. One month’s inflation figures may be set aside as an anomaly, but for the longer term no less a seer than Alan Greenspan, the former chairman of the Fed, reckons that the great days are over of low inflation brought on by China’s entry into the world economy.  


There’s no mention in the Fed minutes of another constraint that worries some economists: pressure on the dollar if US interest rates are set too much lower than the euro’s.  But then the Fed governors probably would not openly talk of this limitation on their freedom of action even if it were a consideration, for fear of spooking markets, and also because, strictly speaking, exchange rate management is not part of their job. Yet if the dollar were to slide as a result of low US interest rates, that would be inflationary and the Fed could not ignore it for long. That is the box that pessimists fear the US economy may be in: the “substantial further easing” required to head off a deep recession might not be possible with a weakening dollar and high oil prices feeding into overall inflation.


They will view oil’s flirtation with $100 per barrel and the return of the euro to its peaks against the dollar, as January has started out, as confirmation of their fears.


The optimists’ case is that interest rates will not have to go to the inflation danger point in order to reignite the economy, and that anyway the weak dollar helps the economy by making US exports grow and encouraging Americans to buy local goods and services. Anecdotally, overseas visitors are rushing to shop for bargains in the States, while fewer Americans are vacationing in pricey spots such as London and Rome, holidaying in domestic resorts instead.




The hard-headed bears concede that this trend is occurring, but suggest it cannot be large enough to offset the collapse in consumption that they see coming. And with new figures showing faltering fourth quarter GDP for Singapore and South Korea – an actual drop of 3.2 per cent for Singapore’s output – there still has to be some question whether the rest of the world will be robust enough to increase imports from the US.


If these economies have been relying on exports to the American market for all their growth, can they switch roles and become more reliant on their domestic consumers for demand, while also becoming buyers of more American goods and services?


At one level, the whole question is whether there is a sweet spot: an interest rate that is low enough to keep consumption and business spending humming along at a reasonable pace despite the ongoing housing crunch, without setting off higher inflation and/or bringing down dollar. When former Treasury Secretary Larry Summers called for targeted tax rebates to keep the economy afloat, he was in effect saying that he, for one, did not believe such a monetary sweet spot exists. The Fed minutes sound much cheerier about the situation being manageable. And in early January the Economist weighed in with a warning that the sort of strong medicine preferred by Summers could be both unnecessary and disastrously inflationary.


Pimco, the leading bond manager, expects the Fed to reduce rates to about 3.25 per cent over the next several months and reflate asset values accordingly.


So far, although not slashing interest rates as deeply as Wall Street wanted in December, the Fed, along with the European Central Bank and Bank of England, has used term auctions to try to ease the bankers’ credit crunch. If banks will not lend to each other for short periods, for fear that they will not be repaid, then the Fed is willing to do so without asking too many questions about the quality of the banks’ collateral. But even if bankers can get their hands on short-term cash, will that give them any appetite to lend to over-extended households as default rates rise on mortgages and possibly on consumer loans, too? Meanwhile, National City, a large, but not leading, commercial bank, just announced that it will be halving its dividend to conserve cash – not a bullish sign – but State Street Bank’s confession that it had to take a $278 million (Dh1 billion) charge for bad sub-prime bets was actually better than the market had feared.


There are lots of feedback loops in our highly complex world economy that could come into play as 2008 rolls along. One concerns the buyout deals that have been falling through recently, the latest being a planned Blackstone/General Electric acquisition of a mortgage origination house, PHH. The big banks who were to have provided the debt for this deal thought better of it – both have been burned by the mortgage meltdown. Although PHH’s business is part of the housing sector, other failed deals have not been – Harman International is a maker of premium sound systems, for example. Will the big drop in deals since mid-2007 have an economic effect? It has surely trimmed the fee income of funds and banks already. Beyond that, private equity was seen as one factor keeping the stock market buoyant, and without stock gains some households would feel less wealthy and might draw in their horns.




On a rosier note, Berkshire Hathaway, the conglomerate run by guru Warren Buffett, is entering the municipal bond insurance business. The traditional muni-bond insurers are in trouble, having gotten into the business of guaranteeing mortgage-backed securities whose risks they apparently misread. Buffett spotted his opportunity, since municipal governments like to keep the interest rates down on their bonds by insuring them for a modest premium, and for that to work the insurer has to look sound. Berkshire Hathaway’s financial solidity almost rivals that of the Federal Reserve. One of the reasons for that is that Buffett is a canny operator and he warned his insurance will not come cheap.


But it is interesting to note that Buffett did not rescue one of the existing muni-bond insurers, choosing instead to create his own new vehicle, which one could interpret as a verdict on the financial trajectory of MBIA and the other bond-insurance players who made the mistake of over-reaching and entering a game that they were ill-equipped to survive. Nor, for that matter, has


Buffett infused capital into any of the major banking players that have turned to sovereign investment funds to make up for their asset write-downs. Perhaps he shares the bearish view that it is too soon to move because there are more banking write-downs to come. If so, those sovereign investment funds have overpaid for their stakes in the big banks.


The latest data on consumer spending makes things look better than the zero growth that nervous nellies were reporting a week ago. Retail sales in the last week of the year were up 14 per cent over 2006 and for November and December taken together sales are estimated to be up by 3.6 per cent.



The numbers


278m – the charge that State Street Bank had to take for bad sub-prime bets.


14% – the increase over 2006 in retail sales in the last week of the year.