Economic stuff

Business Times - 06 Feb 2008

Americans preoccupied with fears of recession

Financial institutions in Wall Street remain very apprehensive about the many 'unknowns'


INVESTORS in Wall Street were biting their nails early last week as they waited for US Federal Reserve chairman Ben Bernanke and his colleagues to decide whether to slash short-term interest rates for the second time in eight days. But with much of the focus of official Washington centering on heated Democratic and Republicans races for the presidential nomination, not many officials and lawmakers were paying much attention to the deliberations that were taking place among the US central bank's policymakers on Tuesday and Wednesday.

Indeed, when the Fed announced late on Wednesday that it was lowering its benchmark interest rate by half a percentage point, the news didn't receive as much play on the 24/7 television news programmes as did the decision by former New York mayor Rudolph Giuliani to withdraw from the Republican presidential race and to endorse his former rival, Senator John McCain who was portrayed now as the Republican 'front-runner'.

But this perceived divergence between Washington and Wall Street was quite misleading. In fact, the majority of American voters are more and more anxious over the dramatic downturn in the American economy - falling home values, credit crunch, rising unemployment, a weakening dollar, rising costs (inflation?) in the energy and food sectors.

And the presidential election campaign is more and more dominated by economic policy issues. Those who are running for the presidency recognise that the policies embraced by the Fed could have major impact not only on the American economy but also on American politics.

Hence, several political scientists and economists have already developed complex models to forecast the presidential elections based on the changing economic conditions that could figure out, for example, that the chances of a Democratic presidential candidate grow by X per cent if economic growth falls Y per cent.

And observers are starting to criticise Mr Bernanke and the Fed, describing their response to the anxiety in the financial markets as excessive or inadequate or as too little or too late.

There has been a suggestion that the Fed 'panicked' when it cut the rate by three quarters of a percentage point two weeks ago. Some pundits are warning that the next White House occupant may not reappoint Mr Bernanke when his first term ends in 2010.

No doubt, politicians in Washington will use Mr Bernanke as a scapegoat if America will find itself in a painful and long economic recession this year, in the same way that his processor, Alan Greenspan, was treated as a superstar when the economy was on a roll. But as economist Alan Reynolds of the Cato Institute pointed out, the US recession that began in July 1990 and ended in March 1991, 'Fed funds rate did not get as low as it is today until 16 months after the recession had ended (which really was too late)'.

Similarly, in the recession that began in July 2001, the Fed Funds rate remained above 5 per cent until April and did not get down to 3.5 per cent until late August.

From this perspective, Mr Bernanke's Fed is actually quicker in its response than Mr Greenspan's Fed. The question is whether the response will also be effective in terms of making the economic downturn shorter and milder.

And in any case, against the backdrop of bad economic news, pointing to a major economic slowdown, including a report showing the economy growing at its slowest rate in five years, soaring foreclosure filings, up 75 per cent last year, and sales of new homes dropping to their lowest level in 12 years in December, Mr Bernanke and his colleagues probably felt enormous pressure to take bold action in the form of an extraordinary amount of easing in a very short period.

The statement issued by the Fed made it clear the policymakers in the central bank were clearly concerned about the economy - pointing to stress in the financial markets, tightening credit conditions for businesses and consumers, a softening labour market, and falling homes prices - and that they were ready to inoculate it as a way of preventing a recession.

The message coming out of the Fed was that downside risks require more interest rate cuts, perhaps in the rest of this year. Most analysts expect the federal funds rate will fall by at least 0.75 per cent more before the year ends.

The Fed's decision to cut rates raises not only economic issues but creates a political dilemma for Mr Bernanke. The previous week's stunning rate cut, which followed the fall in the European markets and the Asian markets, plays into the hands of critics who bash the Fed for paying too much attention to the concerns of investors in Wall Street.

But a refusal to take action, which is bound to create more volatility in the financial markets and will put added pressure on the weak economy and end up igniting other criticism: that Mr Bernanke is too much of a spacey academic who is not 'street-smart' in terms of what's happening in the real financial world.

The Fed insists that its response is based on the recognition that a crisis in the stock market could have a devastating effect on the economy. And it hopes that the combination of the Fed moving so dramatically and the president and the Congress embracing a fiscal stimulus package will give a bit of confidence to investors and consumers that the managers of the economy in Washington are in control of the situation.

With the Fed's key rate now at 3 per cent, it still has enough ammunition in reserve to use if the economy continues to deteriorate. And they certainly could. The financial institutions in Wall Street remain very apprehensive about the many 'unknowns' that could result from the housing crisis and the credit problems.

The Fed and the rest of the officials and lawmakers in Washington, as well as the presidential candidates, seem to be entering into an unknown economic territory that could also determine who will occupy the White House next year.

Copyright © 2007 Singapore Press Holdings Ltd. All rights reserved.


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