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Credit Crisis, Not Recession May Be Fed's Big Worry

Tuesday, 5 Feb 2008 | 9:58 AM ET

The latest economic data have done little to settle the recession debate. But it has raised a bigger question: If the health of the economy is so murky, why has the Federal Reserve been so aggressive in cutting interest rates?

The old Wall Street saying that "the Fed may know something we don’t" probably applies here, but with a twist.

Federal Reserve Bank Chairman Ben Bernanke
Pablo Martinez Monsivais
Federal Reserve Bank Chairman Ben Bernanke

Like Wall Street, the Fed may be more worried about the growing threat from a credit crunch than a recession.

“I worry they know things I don't about the depth of the credit crisis and the balance sheet of companies,” says Josh Bivens, research economist at the Economic Policy Institute, reflecting a growing opinion.

The recent worries about the health of bond insurers--which reversed a stock market rally last Wednesday--show just how dangerous many people think the credit crisis could become.

“My guess is that the Fed has a sort of an amorphous fear of recession snowballing and getting out of hand in an unconventional way,” adds Robert Brusca, chief economist at Fact And Opinion Economics. “The Fed decided not to risk that a weak housing market topped by a recession added to a weakened financial sector that could turn into an economic disaster.”

This might explain why Fed Chairman Ben Bernanke and company slashed interest rates three-quarters of a point a week before a regularly scheduled FOMC meeting and added another half-point cut point on Jan 30 -- having opted to lower rates a mere quarter of a point in early December.

It’s also why economists now say the Fed is poised to cut rates again – the current thinking is half a point off of 3 percent -- if necessary before its next meeting in mid March.

Fed On The Case

It appears the Fed clearly signaled both its thinking and intentions in itsJan. 30 policy statement.

The first sentence of the statement makes the central bank’s priorities and concerns pretty clear.

“Financial markets remain under considerable pressure and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.”

Prior to that, the Fed’s first words addressed the state of the economy and growth.

Secondly, the Fed closed its statement by saying it “will act in a timely manner”, much as it did Jan. 22, explaining its surprise cut as global stock markets fell amid renewed worries about subprime losses.

The Federal Reserve headquarters in Washington, DC.
The Federal Reserve headquarters in Washington, DC.

“The focus is directly on the financial markets,” Bank of Tokyo-Mitsubishi Senior Financial Economist Christopher Rupkey wrote of the statement shortly after its release. “The Fed has not cut rates more than 150 bps in any quarter during the last two recessions. They would only do this if the problem was more Wall Street than Main Street.”

That’s been a growing suspicion of late, particularly in light of Wall Street’s repeated cries for aggressive rate cutting. Those cries, which initially sounded self-centered and self-serving to those worried about Fed policy and moral hazard, are beginning to resonate in more quarters.

“I think it is right to say a lot of current anxiety and uncertainty is coming from Wall Street rather Main Street and it is not always that way,” says William Silber, an author, economist and professor at NYU’s Stern School Of Business, who adds, “One of the problems with the subprime crisis is that it wasn't isolated. The risks were sprinkled across many institutions."

Trouble Spreads

So the credit crunch has not only rippled through Wall Street, it has bled into Main Street and the rest of real economy.

In the financial sector, problems in the subprime mortgage business have been seen in a host of derivative products related to securitized debt. Massive loan write downs and loan loss reserves are becoming commonplace, as seen in the fourth-quarter earnings or guidance of such big firms as Citgroup,Merrill Lynchand UBS, which purchased PaineWebber years ago.

Enormous losses at Countrywide Financial, now a fire sale property forBank of America, have made it a poster child of the boom-to-bust syndrome.

So Wall Street intersects with Main Street, after all, and that’s why concern is growing about the problem spreading just as support is growing for aggressive monetary policy.

Lower rates are an economic stimulus and work a lot faster than the fiscal package coming together in Washington.

“We need to get the yield curve to a point that banks want to lend money again,” says Scott Rothbort, president of Lakeview Asset Management and a professor at Seton Hall's Stillman School of Business.

Rothbort is among those who say the Fed can cut rates to two and a half percent or lower, far from where the fed funds rate was last summer at 5.25 percent.

“I think the most important thing to our financial system – and our banking system -- is clean balance sheets. Clearly we had a breakdown and the Fed can rectify that,” he says.

Other economists say not so fast. In his Jan. 28 research note, Merrill Lynch's North American Economist David A. Rosenberg said aggressive easing, "is a positive for redressing debt-servicing charges but what the rate cuts will not do is trigger credit creation at a time when mountains of bad debt come to the surface in a capital-constrained banking sector."

Lending A Hand

Economists say the next installment of the Fed's quarterly "Senior Loan Officer Opinion Survey on Bank Lending Practices" may provide insights into the credit crunch and lending practices, which the central bank may have been referring to it is FOMC statements.

Bivens among others says those same Fed’s rate cuts will help adjustable rate mortgages, credit card rates, auto loan rates and other consumer loans tied directly to the prime rate because they “filter down relatively quickly.”

But will problems in the consumer sector percolate up as quickly? There’s a growing concern about a vicious circle involving falling home prices, tightening credit and declining consumer demand.

“The average consumer is already in a mode of behaving as if hard times are already here,” says Kenneth Goldstein, an economist at the Conference Board, adding that the thinking is, “If I don't have to do it now, I'm not going to do it now.”

Economists like Nouriel Roubini have concluded that the economy is already in a recession that probably started in December and is likely to stay that way for more than a year because “losses in the financial system are spreading from the subprime area.”

“The market reaction is signaling the Fed can't rescue the economy and severe credit and financial problems,” adds Roubini.

Others are more optimistic about the outcome but just as serious about the challenge the Fed is facing.

The Fed is “unsure about where the economy is headed and pretty determined to keep as many options open as possible,” says Bivens. “I'm worried enough I want everything but the kitchen sink thrown at it.”

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