Economic storm clouds are gathering

When the Federal Reserve Board cut the discount and federal funds rates by 0.5 percentage points Sept. 18, some critics charged that Fed Chairman Ben Bernanke and his colleagues had acted too quickly.
OCT 29, 2007
By  Bloomberg
When the Federal Reserve Board cut the discount and federal funds rates by 0.5 percentage points Sept. 18, some critics charged that Fed Chairman Ben Bernanke and his colleagues had acted too quickly. The critics added that the Fed had reinvigorated what once was known as the "Greenspan put" — that is, the belief that the Fed would bail out Wall Street from its mistakes — and began talking about the "Bernanke put." But now the question is: Was the Fed action too little, too late? Would timelier moves have headed off what appears to be a gathering economic storm? Those questions are being raised because the damage from the subprime-mortgage fiasco appears to be widening beyond Wall Street and the housing market. For example, IBM Corp. of Armonk, N.Y. — not obviously connected to the real estate industry — reported lower hardware sales to financial firms. Other firms likely will similarly be affected in the coming weeks. Add to that the effect on spending of mortgage rate increases on those homeowners who are trying to hold on to their homes, and on those who have lost their homes to foreclosure. And then there is the impact on consumer spending of the layoffs at Wall Street firms and mortgage banking companies. MOUNTING FORCES There is the rise in oil prices to more than $90 a barrel, with some predicting that the price will climb to $100 a barrel before the end of the year. This too will have an impact on consumer spending. As a result of all these developments, the chances of a recession have increased, with some projecting a long and deep slump. And there are signs any recession could be accompanied by inflation as the declining dollar increases the prices of imports, especially imports of raw materials and oil. In fact, the rise in the price of oil is in part related to the dropping value of the dollar. Oil producers no doubt are pushing up their prices to offset the decline in the value of the dollars they are receiving. These factors present the Fed with a difficult problem. If the governors cut rates again to head off a recession, they are very likely to stimulate inflation, which has been slowly creeping up over the past six months. Not only will a loose monetary policy worsen the inflation outlook directly, it will further weaken the dollar as U.S. interest rates become even less competitive with those of Europe. A weaker dollar may further stimulate U.S. exports, but it will also push up the prices of imports and raw materials, further increasing inflationary pressures. On the other hand, if the Fed doesn't cut rates again, a recession will become more likely. That also could weaken the dollar. IN A CORNER In effect, the Fed has boxed itself in, and its options aren't great. Under normal circumstances, the arbiter of the nation's monetary policy wouldn't have to carry the load alone. Fiscal policy would share in helping to head off recession, with the government cutting taxes to stimulate the economy. Unfortunately, given the current budget deficits and the extraordinary partisanship in Congress, tax cuts are off the table. In fact, the Democrats in Congress want to raise taxes. Also off the table is increased Federal spending, which would stimulate the economy, but at the cost of increasing deficits, which might further weaken the dollar. President Bush is belatedly trying to hold the line on spending. If he had done so in the previous seven years, he and the Congress would have more room to maneuver. As it is, financial advisers and their clients should batten down the hatches for possible difficult times. Many signs point to stormy economic days ahead. To be sure, the storm is still over the horizon, and unforeseen wind shifts could deflect it, but it's better to be prepared for a storm that does not hit than to be unprepared for one that does. Mike Clowes is editor at large of InvestmentNews.

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