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Can the Fed steer US out of recession?

February 23, 2008 12:42 IST

While the US may have successfully destroyed a rogue satellite and its potentially lethal cargo of hydrazine high above in space, it will be a difficult task to steer the US out of the recession, which many believe is already underway, on terra firma.

In the last two decades, the US has had two official recessions, one in 1991 and another in 2001. But these were very short, lasting only eight months from the start of the downturn to the beginning of the recovery.

Because of their small duration and the three-month lag with which data is authentically collected, the markets never knew that they were in a recession until the recession had come and gone.

As you read this, the markets are divided on whether there will be a recession. The popular belief is that the sharp reduction in interest rates (with more to come, if the testimony by Bernanke is an indication) taken together with the stimulus package, may prevent a recession in the first half and the economy may rebound in the second half.

But the hopes of economists that these measures would charge the consumer and coax him to spend were dashed as consumer confidence collapsed to its lowest level since 1992.

And on Thursday you had the Philadelphia Fed saying its business activity index, a measure of regional manufacturing activity, had skidded to a reading of minus 24 this month, well below the economists' expectations of minus 10. It was the weakest reading for the measure since the recession of 2001.

These past recessions were caused by deliberate Federal Reserve action that wanted to halt a cantering inflation. The Fed would raise rates to a point where it felt it had slowed down the economy considerably and tamed the inflation. It would then begin to ease and bring the recession to an end.

In stark contrast, the real interest rate this year and last stayed at a relatively low level of less than 3 per cent. The main reason for the current slowdown and potential recession is not Fed action but the bursting of the housing bubble that was built by six years of very low interest rates.

The Fed, thus, will not be able to halt this recession by merely easing rates, something it had successfully done in the past.

House prices are down 10 per cent from their peak 2006 valuations and must fall another 10 per cent to bring a semblance of order in the housing market.

According to a study, each 10 per cent decline cuts household wealth by about $2 trillion, and this eventually reduces annual consumer spending by about $100 billion.

Though the interest rates are down, mortgage rates are up again as banks have become stricter. There is money but banks are wary of lending.

This lack of confidence of the lenders means the Fed policy of reducing interest rates cannot be as effective in stimulating the economy as in the past.

While problems have still not surfaced in the prime loans, indications have started emanating that all may not be well with the best of the companies.

The cost of buying insurance on bonds issued by the top 125 big companies has doubled in the last two months. And we are not talking small fry. We are talking about the likes of AT&T, Wal-Mart and McDonalds.

Corporate-bond prices haven't really fallen as much as the rise in cost for credit-default swaps would suggest. So, in a sense, the rising cost of insurance doesn't reflect the actual likelihood that companies will default.

However, lessons from the mortgage market are that credit-default swaps actually preceded the problems in the market.

Complicating matters further is the runaway rise in commodity prices led by crude, which has a high cascading effect on the economy.

The expectations that a slowing economy would result in cooling commodity prices is not coming true. This inflationary threat will further reduce the elbow room available to Bernanke as he wields the scalpel to cut rates further.

Vinod K Sharma
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