Fed faces risks of inflation, recession

The recent wave of foreclosures and fears about future mortgage defaults continue to weigh on the financial markets, making it tougher — and more expensive — for both home buyers and businesses to borrow money.

“Financial conditions are tighter today than they were a month or two ago,” said Jay Bryson, global economist at Wachovia. “In order to offset that the Fed needs to be easing to try to bring some of those rates down.”

More recently, the focus has turned to the fallout from the housing slump on the wider economy. Since World War II, every downturn in housing has been followed by a recession — with the exception of housing slumps in 1950 and 1966," former Fed Gov. Lyle Gramley noted recently. And in both those instances, “we had big increases in defense spending that kept the wolf at bay,” he said.

Signs of a broader downturn are beginning to appear. The employment report for August, one of the most reliable barometers of the economy’s health, showed an unexpected net loss in jobs for the month. Combined with other data showing weakness, economists have been trimming their growth forecasts for the remainder of the year.

Still, many economists say a recession is far from inevitable. While the U.S. economy is showing signs of slowing, the global economy continues to steam ahead. That — along with weakness in the U.S. dollar — has helped spur a boom in exports, which are up strongly over the past three months

“Usually when we have problems with mortgage defaults, we are in a general recession,” said Susan Bies, a former Fed governor who left the central bank in March 2007. “That is not happening here. A lot of companies are still reporting good earnings. Retail sales are good.”

That’s one reason some Fed watchers remain wary of cutting rates too fast and letting up on the Fed’s perennial battle front — the fight against inflation. Despite Tuesday's good news on wholesale prices, oil prices hit new highs, trading above $81 a barrel. A strong global economy has tightened supplies of building materials and raw commodities like steel. Strong demand for crops that are used for both food and biofuels have driven up food prices.

More on this story Vote: What will Fed do next? |    Stock prices soar after Fed rate cut Home foreclosures soared in August

“We're not just seeing (inflationary pressure) in the price of oil, but also in food prices,” said Michael Pond, a fixed-income strategist at Barclays Capital. “Food-related commodity prices are up 30 percent year on year.”

Aggressive rate-cutting carries another risk for the Fed. The recent turmoil in the credit markets is due, in part, to a period of easy money policy that followed the 2000 collapse of the dot-com bubble — when the Fed, under the leadership of former Chairman Alan Greenspan, cut the benchmark overnight rate to as low as 1 percent. That policy helped fuel the lending spree that pumped U.S. housing prices to unsustainable levels.

Now that the excesses of the lending boom have been reined in, the financial markets still are “repricing risk” — demanding higher interest rates for riskier loans to borrowers like consumers with shaky credit or private equity firms engineering multi-billion-dollar buyouts. If the Fed cuts rates too far, it risks creating yet another credit bubble, starting the cycle all over again.

  

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