Markets

Recession at the Gates

It's going to take more than Fed rate cuts to repair the economy.

By Anne Kates Smith, Senior Associate Editor, Kiplinger's Personal Finance

March 18, 2008

Investors on Wall Street have been worried about a recession for months. Ditto for the folks on Main Street -- especially if they've been trying to sell a house, or just keep up with the payments. Treasury Secretary Henry Paulson stopped short of using the R-word, but admitted the U.S. economy was in a "sharp decline."

Cue another rate cut from the Federal Reserve.

For the sixth time since September, the Fed cut its benchmark rate on March 18, shaving three-quarters of a point from the federal funds rate. At 2.25%, the rate is the lowest it's been since December 2004.

The vote to cut rates wasn't unanimous, an indication that the Fed is fighting to jumpstart the economy without fueling inflation. And the cut wasn't the one-point reduction that some had expected.

Still, investors on Wall Street applauded the cut: The Dow Jones industrial average jumped 420 points, or 3.5%. Even the dollar crept a bit higher versus the euro and the yen.

But even with another cut expected in April to bring the rate down to 2%, an increasing number of economists fear it won't be enough to stave off recession. "The economy is contracting -- no one can debate that,' says Mark Zandi, chief economist at Moody's Economy.com. "Employment growth is slowing, retail sales are shrinking, and industrial activity is weakening. The consensus -- and there wasn't one six weeks ago -- is that this is going to be a recession."

The latest survey by Blue Chip Economic Indicators, taken in early March, found 40% of economists calling for a recession -- and that number is likely at least 50% now, editors say.

We agree that a contraction is likely in the first half of the year. The economic stimulus package enacted by Congress in February will put hefty tax rebate checks in taxpayers' pockets come summer, helping to boost growth in the third quarter.

Whether a recession remains mild or becomes painful and whether a downturn resumes in the fourth quarter are questions as yet unanswered, and policy makers hold the key.

Which key? Certainly not rate cuts alone, says former Fed governor Lyle Gramley. "In previous recessions if the Fed stomped hard on the monetary accelerator, it would stop things. But the Fed isn't gaining much traction. It's a little scary -- the negative dynamics are more ferocious and the instrument you counted on to turn things around isn't working very well."

That's why the Fed has gone outside the rate-cutting box with a series of aggressive moves aimed at putting out fires that continue to spread throughout the economy, from the housing market decline to the credit crunch to a liquidity crisis on Wall Street. The Central Bank said it would lend some $200 billion to 20 big banks in exchange for mortgage-backed debt. Then it agreed to become the lender of last resort for investment banks -- something not seen since the Great Depression. And, of course, it brokered the fire sale of Bear Sterns, rather than risk a wholesale crisis of confidence.

The focus on trying to keep markets stable and get credit flowing again shows that Fed Chairman Ben Bernanke, a student of the Great Depression, has learned his lessons well, says Mesirow Financial economist Diane Swonk. "Easy money is the way to go, with a holistic approach. What matters is not what the fed funds rate is, but whether or not you can get credit."

Even an aggressive, creative Fed can't work magic, however. For the recession to remain mild -- think unemployment peaking at 6% late this year or early next, says Zandi -- further steps are needed from Congress or the Bush administration to address the tanking housing market.

Zandi would like to see the Treasury create an entity that would use taxpayer money to buy mrotgage loans and mortgage securities -- sort of like the old Resolution Trust Corp., which was set up to unwind the savings and loan crisis back in the '80s. The object would not be so much to bail out homeowners as to set a value for mortgage securities, so that the private mortgage market could function again and the housing market could stabilize.

Congress is mulling plans, too, including a second economic stimulus package. It also is considering a proposal for the government to guarantee home mortgages, albeit at reduced values, to give lenders an incentive to work with borrowers to avoid foreclosure. "It's time for the federal government to put some skin in the game and take some of these bad mortgages out of the market," says former Fed governor Gramley.

Failure to act could have catastrophic consequences, he adds. "Worst-case scenario, if Congress does nothing and the administration does nothing, no one knows where the bottom might be. It's potentially that dire."

• Print
• Comments
• Email
• RSS

Reader Comments (11)