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US economy: Tough call for Fed

By Krishna Guha

Published: January 23 2008 07:24 | Last updated: January 23 2008 07:24

The US is in an exceptionally difficult situation, with the economy on the brink of recession and limited scope for policymakers to ride to the rescue.

To some analysts it looks like payback time after a decade in which the US lived beyond its means with the help of generous foreign creditors and a booming housing market.

That view ignores the essential role the US played in supporting global growth for much of the 2000s.

But there is no doubt that the US is in double trouble today because of the excesses of the past and the vulnerabilities associated with global economic imbalances.

The collapse of the twin bubbles in the housing and credit markets is a massive shock for the US economy and one that would be difficult to manage in the most favourable of circumstances.

The US has endured financial market crises before but this turmoil reflects and magnifies a far-reaching development: the sharp reversal in US house prices.

The dual deflation – of housing and housing-related assets – has already devastated home construction and is now threatening to sap consumer spending and erode the lending capacity of the banking system.

Meanwhile dysfunction in the financial system through which monetary policy operates has limited the stimulative effect of interest rate cuts by the Federal Reserve.

The twin bubbles and global imbalances are related, as Robert Dugger of Tudor Investments has argued. The US manufactured hundreds of billions of dollars of securities to sell to foreigners in order to finance its giant current account deficit.

Meanwhile the downward pressure of excess savings outside the US on government bond yields induced investors of all kinds to seek ways to boost yield, compressing risk premiums to unsustainably low levels and – among other things – fuelling the subprime mortgage market.

Now the housing/credit market bust is moderating the current account imbalance – and the savings/investment balance that is its counterpart.

But as Martin Feldstein, a professor at Harvard, says, it is happening “through a reduction in investment primarily in housing rather than an increase in saving”.

A substantial fall in the dollar was required to deliver the external adjustment that has taken place so far: economists differ as to whether more will be needed.

On the plus side, world growth remains strong, providing a much-needed lifeline for the US. Net exports should continue to lend some support to US growth in the coming quarters, though not as much as in the middle of 2007.

On the minus side, the Fed – like other central banks – has to cope with the risks to inflation from the oil price shock caused by surging demand for energy in China, India and the rest of the emerging economies.

The still very large current account deficit makes the Fed balancing act vastly more difficult. With little scope to inflate more asset bubbles at home, one of the main ways in which monetary policy works is through the dollar and net exports.

The significant decline in the dollar since the credit squeeze began is not an accident – the Fed needed the dollar to fall to stimulate the US economy.

But the US central bank’s ability to cut rates aggressively is limited by the structural vulnerability of the dollar arising from the external deficit.

Indeed, the events of the past year or so constitute close to a perfect storm for the dollar, with a deterioration in both US short-term and long-term growth prospects, declining interest rates on US assets and a shock to confidence in the transparency and liquidity of US financial markets.

Excessive rate cuts could push oil up further and unleash inflation expectations when US headline inflation is high and core inflation creeping up.

The Fed is widely criticised in the financial markets for being behind the curve on monetary policy. But with inflation consistently above the Fed’s implicit target, a large external deficit and a vulnerable currency, the Fed was almost obliged to stay a fraction to the hawkish side of the market. The Fed now appears to be throwing caution to the wind and adopting a more aggressive stance on rate cuts.

This holds out some promise for growth, but brings the risks to inflation and the dollar closer. Ben Bernanke, Fed chairman, is presumably betting that recession fear will tamp down price and wage pressure. But if inflation expectations start to move up, the Fed will be in a real bind.

Meanwhile the Fed’s dilemma explains why so many top economists in the US are now advocating a fiscal stimulus to bypass the financial system, boost spending, and take some of the pressure off the central bank and monetary policy.

Such a stimulus now looks likely. The question is whether it will come in time to do any good. A fiscal stimulus will reduce US national savings further, and put upward pressure on the current account deficit, though not dollar for dollar.

From the US point of view what might be even more helpful would be stimulus – monetary and fiscal – in the rest of the world.

Krishna Guha is the FT’s US Economics Editor

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