Fed eyes rate cuts to calm market

The central bank eased jitters Friday, but analysts wonder if it's enough to avoid recession.

from the August 20, 2007 edition

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The Fed has overestimated the inflation threat, says economist Lincoln Anderson of Boston-based LPL Financial Services. The core inflation rate, the rate not counting energy or food, is now down to 1.9 percent, he points out. This rate is within the Fed's comfort zone. "Why tilt against an inflation surge when that is not happening?" he asks.

If the Fed does cut rates, it will come at a time when the economy is still showing that it has some spunk left in it. Last week, the government reported that July industrial production rose at an annual rate of 0.3 percent after rising 0.5 percent in June. Exports are rising and business is beginning to spend more on inventory replenishment.

"The economic data is not all that bad," says Jay Bryson, a senior economist at Wachovia in Charlotte, N.C. "The economy is growing at about 2.5 percent to a 3 percent rate."

But, that economic activity took place before the current credit crunch.

Mr. Carey says his economic modeling shows the restrictive credit conditions could take as much as 0.5 percent off economic growth next year. This would put economic growth below 2.5 percent next year, below trend. "There are a lot of downside risks," he says.

One of those risks, says Gramley, is that the housing market slows even further as it becomes increasingly difficult to get a mortgage because banks can't resell them in the secondary market.

"We need to inject some liquidity into the secondary market [for mortgages], which is completely frozen," he says. "Unless the administration wakes up, the recession will begin in November or December of this year," he warns. "And it may not end until next September, which is right around the corner from Nov. 6," Election Day.

Gramley believes the way to inject liquidity is for the Bush administration to temporarily lift the ceiling on the holdings of Fannie Mae and Freddie Mac, the quasi-government buyers of mortgages. Both agencies have reached the maximum amount they can hold in their own portfolios. Only last week, President Bush said he wanted the two entities to undergo reforms before he would allow them to increase their portfolios.

On Friday at a press conference, Sen. Christopher Dodd (D) of Connecticut urged Mr. Bush to act. He estimates the move could add about $80 billion in liquidity to the mortgage market.

"There is enough regulatory authority for the caps to go up 5 percent without violating existing law," said Senator Dodd, chairman of the Senate Banking, Housing, and Urban Affairs Committee. "The idea [that] we do reforms first is not a legitimate answer."

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