Just as we were putting this issue to bed, news broke that the Federal Reserve had extinguished a fire in the global stock markets by lowering its federal funds target rate by 75 basis points to 3.5%. While some economists argue that it was a hasty decision heavily influenced by Wall Street that could fan the flames of inflation down the road, others believe that it's a small step in the right direction.
The economy is growing and will keep growing, insists Ken Simonson, chief economist with the Associated General Contractors of America. “They [the Fed] are acting well ahead of any clear-cut evidence that we're in a recession. I'm still concerned about inflation, and I'm surprised that the Fed seems to have jettisoned all those concerns and is focusing entirely on the possibility of a recession.” General contractors, for example, continue to face significant price increases in diesel and steel.
Simonson's argument is compelling. The Fed's own Beige Book shows growth still occurring in many regions and employment sectors. The U.S. economy has generated jobs for a record 52 consecutive months through December 2007. Non-residential construction spending rose at an annual rate of 18% in November 2007.
Why such a deep cut now? “The equity markets are starting to price in a global slowdown,” says Edward Leamer, director of the UCLA Anderson Forecast. The Fed doesn't want to be in a position of appearing to be insensitive to economic conditions, if the conditions predicted by the equity markets materialize.
Leamer forecasts the U.S. economy will grow between 1% and 2% during the first and second quarters of 2008. That weakness largely stems from a slump in housing starts, which have been in a freefall and are expected to bottom out in the second quarter of this year. At the height of the boom in January 2006, the annual rate of seasonally adjusted housing starts was 2.2 million compared with just 1 million in December 2007.
The credit crunch is really limited to the mortgage arena, Leamer says. The malaise affecting Wall Street, which is reeling from billions of dollars in write-downs largely tied to subprime mortgages, isn't spilling over onto Main Street. “The real economy lives and dies on the basis of firms making real investment decisions: building new factories, new offices or buying equipment. There is no evidence of the so-called credit crunch affecting that activity.” Because of fairly strong cash flows, many corporations still have little need to borrow.
Mark Dotzour, real estate economist at Texas A&M University, says the rate cut was a step in the right direction but doesn't address the housing situation. “You just have a lot of people out there who are sitting on houses that are declining in value. That value decline isn't going to end overnight just because the Fed cut the interest rate by 75 basis points.”
As of mid-January, interest rate spreads on 30-year, fixed-rate mortgages were about 210 basis points over the 10-year Treasury, much higher than the spread of 150 basis points historically. Dotzour proposes an emergency bond insurance program in which FHA would guarantee all conforming conventional mortgages for the next 18 months. That would help lower the spreads and juice the economy, he believes.
Overshadowing the Fed's interest rate cut, Dotzour says, was the downgrade of Ambac Financial Group, a giant bond insurer, from AAA to AA only days earlier. The downgrade came after Ambac announced a $3.5 billion write-down on the value of bonds it guarantees. Those guarantees were tied to subprime mortgages that plummeted in value.
“If the global financial market is a 20-story office building, those monoline insurance companies are the concrete pillars that were driven 15 feet down into the earth to provide stability for the whole structure. Those pillars are not only cracked, but totally crumbling,” says Dotzour.
The concern is that if a bond insurer is downgraded, the securities it guarantees also will be subject to downgrades, leading to additional write-downs for investors. “So much of this credit paper is sold with bond insurance on it,” says Dotzour. “If the insurance company can't honor its commitment, then the value of that insurance and the value of that AAA credit rating goes out the window.”
Dotzour says that the Fed's decision helped staved off a big drop in the stock market on the day of the announcement. “But the fact is, the credit markets are still in complete disarray.”
Matt Valley can be reached at firstname.lastname@example.org.