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All eyes on Fed as main line of defence against recession

Many sceptical that spending measures, tax cuts will help

(CHICAGO) Concern that the Federal Reserve’s interest rate cuts will have a limited impact on economic growth, and may risk fuelling inflation, have led to calls for a fiscal policy boost for the US economy.

But many are sceptical that Congress or the White House can pull a rabbit out of the hat with new spending measures or tax cuts, leaving the Fed as the main line of defence against a recession.

Perhaps with that in mind, Fed chairman Ben Bernanke ‘showed a brazen, ‘throw caution to the wind’ approach’ when he vowed last week to act in a decisive and timely manner to support the economy, said Alan Ruskin, chief international strategist with RBS Greenwich Capital in Greenwich, Connecticut.

US President George W Bush has said that he is mulling steps to boost the economy, lawmakers are scrambling to sketch out proposals and a number of leading presidential candidates have thrown their thoughts into the ring.

Prominent economists and former government officials have also joined the fray. Last week, former Treasury secretary Robert Rubin called for US$100 billion in fiscal stimulus to help boost investor confidence.

Rising defaults on US home mortgages led to a near freeze-up in money markets in August as banks, fearful of taking on bad collateral, recoiled from lending to each other.

With credit markets still fragile, the tilt towards a fiscal solution reflects worries that the Fed’s cuts to short-term interest rates will have less impact than usual.

‘Interbank markets are still exhibiting symptoms of increased risk-aversion,’ Bharat Trehan, research adviser at the San Francisco Federal Reserve Bank, said in a report on Monday.

Although risk-related interest rate spreads such as the London Interbank Offered Rate, or Libor, have come down recently, ‘things don’t look nearly as good in the longer-term markets’, he said.

Rates on so-called ‘jumbo mortgages’, those above the US$417,000 upper threshold of what mortgage finance companies Fannie Mae and Freddie Mac can buy, remain high, and although the rates on smaller mortgages have come down as 10-year Treasury yields have declined, the spread to Treasuries is higher, Mr Trehan said.

In addition, some Fed policymakers remain wary of inflation. A report due yesterday was expected to show that the US core consumer price index, which strips out food and energy prices, rose 0.2 per cent last month, which would take the year-on-year rate up to 2.4 per cent from 2.3 per cent.

Aggressive interest rate cuts from the Fed could exacerbate inflation risks, in part by pushing down the value of the US dollar on foreign exchange markets.

‘Fiscal stimulus would probably pose less risks to the dollar than monetary easing, and thus could carry less inflation risk,’ said strategists at 4CAST Ltd.

The stimulus debate inevitably circles back to the sick housing market, the main element driving the US to the brink of recession and the main stumbling block to a return to higher growth.

‘In this cycle, the Fed is likely to get much less real economic traction out of (lower) yields, because of severe limitations to how much they can reflate house refinancing activity,’ Mr Ruskin said.

Many analysts expected US home prices to fall into 2009, limiting buying interest even among the smaller pool of potential buyers able to obtain financing in the more restrictive environment.

While a fiscal boost might be good medicine for the economy, analysts warned that anything to emerge from Congress could be too late. Most forecasts called for economic growth to trough out in the next couple of quarters.


Source: Reuters (Business Times 17 Jan 08)


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