Federal Reserve’s Comments On The Current (Dec 2007) State Of The US Economy

Federal Reserve policy-makers worried that a credit crunch could sharply brake economic growth and require big interest rate cuts, according to minutes of the Fed's December 11 2007 policy meeting.

“The Fed minutes showed policy-makers' growing concern that signs of economic softening coupled with credit market strains were a risk to the economic expansion. Fed staff revised down their estimate for growth in the final months of 2007, and projected the economy to expand at a rate "noticeably below its potential" in 2008. "Growth in late 2007 and during 2008 was likely to be somewhat more sluggish than participants had indicated in their October projections".

Some members noted the risk of an unfavorable feedback loop in which credit market conditions restrained economic growth further, leading to additional tightening of credit; such an adverse development could require a substantial further easing of policy.

At the same time, Fed officials realized that financial market conditions might improve more rapidly than they expected, which would make it appropriate to raise borrowing costs, reversing earlier cuts.

The Fed cut rates by a quarter-percentage point to 4.25 percent at the meeting. Boston Fed President Eric Rosengren dissented, preferring a more aggressive rate cut. Risks to growth had risen since their previous meeting in large part due to deteriorating credit markets. Even so, the policy-makers weighed the lagged impact of cumulative interest rate cuts, and a strong labor market, which suggested the economy retained some forward momentum.

Although members agreed that the stance of policy should be eased, they also recognized that that the situation was quite fluid and the economic outlook unusually uncertain.

The housing correction was likely to be deeper and more prolonged than anticipated, Officials also took note of a "marked deceleration" in consumer spending.

In the meantime, the U.S. economy still appears to be on shaky ground recession risks have risen in recent weeks.

Financial markets fully expect the Fed to cut interest rates by at least a quarter-percentage point at its next policy meeting January 29-30 2007 and a report on showed factory activity contracted in December 2007 led traders to increase bets on a half-point reduction.

In another worrisome sign, U.S. crude oil prices hit a record high of $100 a barrel.

Fed officials on December 11 2007 saw inflation readings as less favorable than they had been in the past, but anticipated an easing of core inflation, which strips out food and energy.

2008 The Global Economic Trend

Will the financial crisis continue in 2008? Will inflation expectations rise further? Will there be a disorderly process of global rebalancing? What about the rest of the world? Can it decouple?

North America remains the global economy's hub. Any assessment of the world economy in 2008 depends on the likelihood, depth and length of a US economic downturn and the magnitude of a global spillover.

Any forecast is thus contingent on how we answer the following three questions. Will the financial crisis continue in 2008? Will inflation expectations rise further? Will there be a disorderly process of global rebalancing? What about the rest of the world? Can it decouple?

If we answer all three questions with Yes, we should prepare for a global depression. If the answer is No, the world economy will have another good year. There are many intermediate scenarios as well.

1. Will The Financial Crisis continue In 2008?

Yes. The financial crisis will probably linger on for most of the year (2008) and may get worse before it gets better. This is not really a "subprime" or "credit" crisis, as it is frequently called. This is a banking crisis. Economic history has taught us time and again that banking crises do not simply go away.

This banking crisis has proved persistent because it interacts with the real economy and with other parts of the financial market - the mortgage market, the money markets and various pockets of the bond markets. Furthermore, this is not a liquidity crisis at its core, even though a lack of market liquidity appears to be one of its many symptoms. What has made it so severe and immune to monetary policy is that financial actors no longer have blind faith in the solvency of their counterparties.

Nor will this crisis be over the minute that all subprime-related junk has been fully accounted for. There are many other parts of the credit market that were subject to hype similar to that of subprime mortgages, for example leveraged loans. The risk of contagion is particularly great if the US falls into a recession. In this case corporate bankruptcies would rise sharply and this would immediately hit the market for credit default swaps, complex financial instruments that offer insurance against non-payment of bonds. In this market, too, exposure risks may have been greatly underestimated.

The macroeconomic effects of a financial and banking crisis of such scale are not trivial. Economic forecasters frequently underestimate the importance of credit and financial channels. What saved the US economy during the 2001 recession was a booming housing market and the availability of cheap consumer credit. This time (2007-2008) many of those mechanisms work in reverse. The housing markets in the US and several other economies are headed for a severe downturn. In fact, it is a testimony to the innate strength of the US economy that it has produced positive growth rates until recently.

2. Will Inflation Expectations Rise Faster?

The second risk is inflation - for two reasons. First, persistent high inflation could destabilise global government bond markets, a rare pillar of stability in an uncertain financial environment. Second, high inflation places constraints on monetary policy. This in turn could make the downturn harder and longer, and the banking crisis more severe. The problem for central banks is not the rise in headline inflation rates, but the rise in inflationary expectations. A sharp economic downturn would almost inevitably reduce headline inflation rates, owing to lower oil and food prices. But it would not necessarily reduce expectations of future inflation.

Inflationary expectations went up worldwide during 2007, partly because of rising headline inflation, but possibly also because central banks may have lost a part of their credibility as they appeared torn between conflicting objectives of price and financial stability (In the eurozone, for example, five-year inflation futures show that the financial markets expect medium- term inflation to be about 2.5 per cent. Markets obviously distrust the European Central Bank’s medium- term inflation target of close to 2 per cent. In the US, the markets have little faith in the US Fed’s comfort zone for core inflation, either)

3. Will There Be A Disorderly Process Of Global Rebalancing?

The third risk is a disorderly unwinding of global imbalances, in particular a collapse in the exchange rate of the dollar against the euro and the yen. That could occur if central banks in Asia, Russia and the Middle East were to shift reserve assets out of dollars on a large scale. On this score, it is more optimistic.

The decision by China Investment Corporation to take a $5bn stake in Morgan Stanley is a sign that China is not about to shift investments out of dollar assets into euros. Also, the latest US Treasury Intl Capital system data show that capital flows were returning to the US in October 2007, after a few months when it appeared that the US capital account surplus was disappearing.

Going Forward … Taken together, the credit crisis is expected to get worse before it gets better, that persistently high inflationary expectations will place constraints on central banks and that there will be no dollar crisis.

This hypothetical scenario would almost certainly produce a serious slowdown in US economic growth and quite possibly a recession.

4. What About The Rest Of The World? Can It Decouple?

The answer is No. Both Asia and Europe should expect to see a significant reduction in economic growth, too. Asia will be mainly affected through the trade channel, given its reliance on the US as consumer of last resort. The biggest crisis transmission mechanism to Europe is the financial market.

But Asia and Europe are in a relatively strong position to avoid recessions. Asia's economic health will rest crucially on continued financial stability. The biggest current risk to China, for example, would be an implosion of overvalued stock prices. In the eurozone, there are already signs of an economic downturn, but fiscal policy could prove to be an important counter-cyclical stabiliser this time. One of the most vulnerable economies in Europe is the UK, which is heavily dependent for its economic performance on housing and credit, and where the scope for fiscal policy is more limited.

The bottom line is that this year (2008) marks the start of an asymmetric global economic downturn that is likely to persist for some time and will probably be quite unpleasant, but which will be well short of catastrophic.