Wall Street's 'overreaction'

Is a recession a serious risk - or is it mostly in Wall Street's mind?

Financial markets have descended into a major funk in the past two weeks, driving key stock indexes to their lowest levels in more than a year.


But some analysts say the action in stocks and bonds is overstating the chances of grave trouble in the economy.

And they contend the Federal Reserve, Congress and the Bush administration are being goaded by markets into stimulus measures that may be costly and even unnecessary.


"The administration, Congress, the Fed and the day traders on Wall Street all seem to be in panic mode," said Allan Meltzer, a veteran economist and Fed-watcher at Carnegie Mellon University.

To be sure, perhaps the majority of economists would argue that it's better for policymakers to be safe than sorry with their responses to the housing market slump and the risks it poses to the broader economy.

Yet despite the slowdown in business and consumer activity in recent months, there is no consensus that the economy is heading for a recession.

In its latest report on regional trends, the Fed said Wednesday that the expansion continued in late November and December, albeit "at a slower pace."

In a Bloomberg News survey this month, 62 economists projected on average that the economy would grow at a 1.5 percent annual rate in the first half of this year, less than half the pace of recent years but still positive.

And there has been some good news for the economy amid the slowdown. For example, 30-year mortgage rates have dropped below 6 percent to the lowest level in more than two years, a boon for many people hoping to take advantage of falling home prices.

But on Wall Street the gloom has just thickened in the new year.

Major stock gauges continued their slide yesterday, with the broad Standard & Poor's 500 index falling 2.91 percent to 1,333.25, its lowest since November 2006.


The Dow Jones industrial average also gave up more ground, losing 306.95 points to 12,159.21, and now is down more than 6 percent since the year began - nearly wiping out its entire gain for 2007.

Some investors who are fleeing stocks are buying government bonds for their perceived safety - accepting extremely low yields on the securities, including a mere 3 percent annualized yield on five-year U.S. Treasuries, the lowest since 2003.

All this smacks of deepening pessimism over the economy that some analysts say is unwarranted.

"This is a classic overreaction," said David Kelly, market strategist at investment firm JPMorgan Funds in New York.

Markets, he noted, have a history of wild mood swings that often are dead wrong in what they purport to say about the economic outlook.

One issue now, Kelly and others say, is whether the Federal Reserve risks being trapped by crumbling markets into making bigger interest rate cuts than it might like. The Fed has cut its benchmark short-term rate by a full percentage point, to 4.25 percent, in three moves since mid-September.


What's more, Fed Chairman Ben S. Bernanke last week promised "substantive" further rate cuts to help the economy. He gave essentially the same message when he testified yesterday before the House Budget Committee.

Despite Bernanke's latest promise on rates, however, "The Fed has not been effective at restoring investors' confidence," said Diane Swonk, an economist at investment firm Mesirow Financial.

Some bond market investors in recent days have said they expected the Fed to make a bold rate cut, perhaps as much as 0.75 of a point, at its Jan. 29-30 meeting to show a commitment to staving off recession.

But does the economy need lower rates to stay on a growth track?

One of the main concerns of policymakers has been the risk of a worsening credit crunch stemming from the housing market's woes, as lenders that have suffered heavy losses because of rising mortgage delinquencies cut back on extending loans.

There have been some signs, however, that efforts by the Fed and other major central banks have been calming credit-market fears. Since early December the rates bank charge one another for short-term loans have dropped significantly in the so-called LIBOR market (which stands for London Inter-Bank Offered Rate), which is closely watched for signs of financial system stress.


"Some of what they've done is clearly working," Swonk said of central banks' efforts.

She also noted that cuts in the Fed's federal funds rate typically take six to 12 months to work their way into the economy, which means the most recent three cuts would be expected to buttress business and consumer activity in spring and summer.

If stocks keep dropping and investors continue to rush into government bonds, however, the Fed may have little choice but to respond with bolder rate moves in the next few months, analysts say.

Tom Petruno writes for the los Angeles Times.