Move to avoid recession

Updated: Sep 30 2007, 08:26am hrs
So far, so good. In the past month, the Federal Reserve has boldly cut its target for the key federal funds rate - which banks charge one another for overnight loans - by half a percentage point to 4.75%, and twice lowered its discount rate. It also injected $263.5 billion in temporary reserves into the banking system. These steps and others executed by central banks from Frankfurt to Tokyo have helped calm jittery markets. Even so, the Fed will have to do more, including cutting the Fed funds rate further and possibly accept asset-backed commercial paper as collateral for loans to banks. The US government should also adopt fiscal remedies to help alleviate the subprime crisis. Traders are betting there is an 86% chance the Fed funds rate will be cut to 4.5% when the central banks decision-making Federal Open Market Committee meets on October 31, according to futures contracts.

As for the Fed broadening the range of collateral it accepts to include asset-backed commercial paper, it would spell the monetisation of these securities. By doing so, the Fed would effectively guarantee the commercial-paper market to be liquid, causing its spread to collapse immediately, says Chen Zhao, chief global strategist at BCA Research Ltd in Montreal.

On the fiscal front, the Bush administration is considering options to help distressed homeowners, and Treasury secretary Henry Paulson addressed the issue in September 20 remarks before the US House of Representatives Committee on Financial Services.

Why are these changes needed To restore confidence among creditors. Simply put, the credit-market crisis is far from resolved. The commercial-paper market ground to a standstill. The gap, or spread, between the yields on corporate bonds and US Treasuries has widened. And confidence in the quality of financial institutions balance sheets has been undermined.

Still, these concerns shouldnt keep the Fed from dealing with its main tasks: restoring confidence in markets and financial institutions, preventing the US from falling into a Japanese-style liquidity trap, where ultra-low interest rates couldnt rejuvenate the countrys economy, and avoiding recession. In case you doubted the Feds commitment to lifting the long shadow the global liquidity squeeze is casting over international credit markets and the global economy, remember that the decision to lower rates was unanimous among the 12 members of the FOMC.

Sure, cutting rates, monetising bad debts and helping home owners pay their mortgages constitute bailouts for everyone from poor folks to billionaires. They probably mean that Fed chairman Ben Bernanke will forever be known by the unappealing epithet Helicopter Ben. And the Fed may risk reigniting inflation and spawning new bubbles, which will have to be reckoned with at some future date. Not everyone being hurt by the credit crisis is a speculator who placed the wrong bets, a mortgage arranger who falsified documents or a homebuyer with too many debts.

The Fed can always quickly retract tightening if their aims are fulfilled and thereby avoid the mistakes of the Greenspan Fed when emergency easing was not reversed quickly enough, says Alan Ruskin, Greenwich, Connecticut-based chief international strategist at RBS Greenwich Capital Markets.

The Fed has signalled it understands the gravity of the situation; that is a very good thing. Can the pump-priming work History says yes. Fed monetary reflation in the past has always managed to turn the US economy around, Chen says.

Theoretically, lower interest rates resuscitate economic growth by reducing the cost of borrowing for both companies and individuals. Lower rates can also weaken an exchange rate, which in turn makes companies more competitive, while also increasing the value of overseas sales and earnings when they are translated back into a corporations base currency.

Whats more, lower rates can prompt stock prices to rally, reducing the cost of capital. Most importantly, lower rates can lead to job creation and income growth, helping to buoy property prices and consumer spending.

All of these moves are in the direction of stimulating economic activity, which encourages businesses to take on more risk and stabilise the financial system through a steepening yield curve, Chen says.

More good news is that the US should be able to sidestep Japans problems and a recession.

After Japans asset bubble burst in 1990, the nations monetary authorities kept raising interest rates and continued to tolerate a strengthening yen. The result was an economy beset by stagnation and deflation. Its hallmarks were a 13-year equity bear market, a real-estate collapse that devastated the collateral supporting bank loans and a decline in bank lending.

In contrast, the Fed has begun cutting rates, the dollar is already very weak and U.S. banks - regardless of the mortgage mess - arent about to collapse. Similarly, a boom in exports and low US corporate indebtedness dont point to a severe slowdown. Recession is always preceded by a bear market, yet as of September 26 the Standard & Poors 500 Index was down only 1.8% from its July 19 peak.

Nonetheless, the longer the credit crunch lasts, the bigger the risk of recession. So although the Fed has performed well so far, it cant afford to relax.

Bloomberg / Michael R Sesit