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Treasury Official Says Fed's Credibility "Rock Solid"

Reuters
Tuesday, 26 Feb 2008 | 8:01 AM ET

The U.S. Federal Reserve's credibility on inflation remains untarnished by its aggressive easing of monetary policy in the face of rising price pressures across many global commodity markets, a senior U.S. Treasury Department official said on Tuesday.

"The Fed's credibility on inflation is rock solid," said Phillip Swagel, Treasury Assistant Secretary for Economic Policy, adding: "overall, inflationary expectations remain contained."

The Fed has slashed interest rates in recent months in a bid to rev up an economy many analysts say is on the brink of or actually in recession as a result of the credit crisis.

The Fed's action, together with a weak dollar and soaring commodity, energy and food prices have fuelled fears inflation is taking hold just as growth is slowing.

In a show of hands, however, the packed hall of delegates at the Euromoney Bond Investors Conference in London overwhelmingly disagreed with both Swagel's assessments.

They reflected the view that the U.S. economy is either in recession or about to slip into one and that the Fed has let the inflation genie out of the bottle.

But Swagel was more optimistic.

"The surprise, given the (price) shocks we're facing, is how modest the feed through to core inflation has been," Swagel said.

One example of this is the yield on Treasury inflation-protected securities, or TIPs, which is one barometer of investors' inflation expectations. These yields have risen in recent weeks but to levels seen in 2004, suggesting there's no need for panic.

Swagel, economic adviser to Treasury Secretary Henry Paulson, said the Fed's action and the White House's fiscal stimulus package of up to $160 billion to take effect in the coming months will help cushion the economy from the crumbling housing market and subsequent credit crisis.

"We think the fiscal package is big enough to support the economy. It will support demand in the second quarter but especially the third quarter," Swagel said.

"The stimulus is big enough to matter but not big enough to pose a fiscal challenge."

The main near term challenge for the U.S. economy is working through the housing market crisis, although it's not all doom and gloom. For example, 77 percent of U.S. subprime borrowers are still making good on their mortgage payments, Swagel said.

Efforts to save homeowners from foreclosure should not unduly alter the contracts behind troubled loans. Proposals that "would retroactively change contracts on existing loans" could cause long-term harm to the housing finance system, Swagel said in prepared remarks.

Such a move "would make it more difficult for future subprime borrowers to get into a house in the first place," he said, addressing the Euromoney Bond Investors Congress in London. A copy of his speech was released in Washington.

In recent months, a large share of homeowners who relied on the easy terms of subprime loans have faced foreclosures as their interest rates have spiked and the nation's housing market has flattened.

Swagel said the Treasury Department is examining whether there is enough market discipline in the current mortgage finance system.

"The originate-to-securitize model succeeded in dispersing risk ... but had the unwelcome effect of also dispersing information," he said.

Investors had too little information about the true risks of mortgage-backed securities collateralized debt obligations and other products that helped fuel the recent housing finance bonanza.

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