Economic ills raise pressure on Fed

WASHINGTON — WASHINGTON -- The Federal Reserve faces enormous pressure to reduce interest rates on Tuesday as the economy appears to be taking a turn for the worse, chiefly because of a housing-induced credit crunch that largely caught the central bank by surprise.

The Fed's credibility with financial markets and the American people is on the line.


Both Wall Street and Main Street expect it will reduce interest rates at least by one-quarter of a percentage point, and perhaps more, to ease credit conditions. It could be the first of several such reductions in borrowing costs, they say.

If the Fed instead keeps interest rates steady, "it would be an unmitigated disaster," said David Jones, a retired Wall Street economist and author of a book on the central bank.


"It's inconceivable that they won't cut rates," added Peter Kretzmer, an economist at Bank of America.

The central bank's last interest-rate reduction occurred in June 2003, when it took its benchmark "federal funds" rate to 1 percent to bolster the economy. This rate, which banks charge each other for loans, is now at 5.25 percent. In today's economic climate, many analysts say it is now too restrictive for the economy to grow.

Fed Chairman Ben S. Bernanke, who has taken much flak for not reacting sooner to the credit problems, is facing his first big test since taking over for Alan Greenspan last year.

Critics say he's either too academic or too aloof from financial markets and - the harshest criticism of all - that he is no Greenspan, noted for his instinctive market interventions.

The Fed's decision is not only economic. It's also political, because it occurs in the middle of a presidential campaign in which President Bush's economic policies are being called into question. Bernanke was Bush's chief economic adviser before taking on the Fed job. If a Democrat wins the White House, Bernanke's reappointment would likely be in jeopardy.

Although Treasury Secretary Henry M. Paulson Jr. told reporters this week that "we have, in my judgment, a healthy economy," economists on Wall Street and Main Street see a recovery in deep trouble. The business school at UCLA issued a forecast this week noting an economy currently suffering a "near recession experience." Its chief forecaster, Edward Leamer, gave the central bank an "F" for moving too slowly to counteract a housing bubble that began several years ago.

A survey of chief financial officers by Duke University and CFO Magazine said these corporate executives are the most pessimistic about the economy they have been since the first survey was taken six years ago. A recession is a "distinct possibility," said John Graham, a finance professor at Duke's business school. A panel of economists for The Wall Street Journal also said that the odds of a recession had grown.

The chief reason is that loose lending practices in the so-called "subprime" mortgage market aimed at borrowers with a poor credit history could spill over to the rest of the economy and hurt consumer spending, business investment and hiring. Some analysts say that the Fed itself helped promote the subprime lending market because of low interest rates that prevailed under Greenspan.


These loose lending practices spread like a cancer to other markets, carried by the practice of issuing securities against mortgages and then selling them to investors across the economy. Now, investors do not want these securities but have a hard time selling them.

Paulson told reporters that trying to contain the situation and returning credit markets to normal "will take a while. I don't believe there are quick fixes to this issue." He added that the credit-market problem would "penalize" economic growth, but not cause a downturn.

A strong international economy is helping U.S. exports and producing jobs, Paulson said.

But the employment market has taken a recent hit. Payrolls shrank by 4,000 jobs last month, according to the Labor Department, presenting the first hard evidence that the housing problems are spilling elsewhere. In a report yesterday, the department said the number of laid-off workers filing for unemployment benefits rose by 4,000 last week to 319,000.

Lyle Gramley, a former Federal Reserve governor, said that since World War II significant housing declines in the United States usually have resulted in recessions. Only two such declines, in 1950 and 1966, did not lead to a downturn because of heavy wartime spending at the time, he said.

Although employment has held up until now, Gramley said he expects that "as business recognizes that this slowdown is here to stay, this [the labor market] could get worse. We are now in a different phase of business hiring practices."


Ed Peters, chief investment officer at PanAgora Asset Management in Boston, called for a more cautious Fed policy, saying a small rate cut would do little other than to raise morale in the market.

He and others said the central bank could also reduce its discount rate - what it charges banks for loans - again. The Fed cut the rate from 6.25 percent to 5.75 percent on Aug. 17.

Jim Baird, chief investment officer at Michigan-based Plante & Moran Financial Advisers, said a rate cut of a quarter of one percentage point is likely. But he added that the central bank would probably reduce interest rates at least two more times before the end of the year to bolster the economy.

These projected rate cuts, along with a strong global economy, "should be sufficient to avoid a recession," Baird said.

William Neikirk writes for the Chicago Tribune.