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Sunday, November 25, 2007

Do We Need Another Rate Cut?

Larry Summers wonders what we are waiting for:

Wake up to the dangers of a deepening crisis, by Lawrence Summers, Commentary, Financial Times: Three months ago it was reasonable to expect that the subprime credit crisis would ... not ... threaten ... economic growth. This is still a possible outcome but no longer the preponderant probability.

Even if necessary changes in policy are implemented, the odds now favour a US recession that slows growth significantly on a global basis. Without stronger policy responses..., moreover, there is the risk that the adverse impacts will be felt for the rest of this decade and beyond.

Several streams of data indicate how much more serious the situation is than was clear a few months ago. First, forward-looking indicators suggest that the housing sector may be in free-fall from what felt like the basement levels of a few months ago. ... [I]t is hard to believe declines of anything like this magnitude will not lead to a dramatic slowing in the consumer spending that has driven the economy in recent years.

Second, it is now clear that only a small part of the financial distress that must be worked through has yet been faced. On even the most optimistic estimates, the rate of foreclosure will more than double over the next year...

Third, the capacity of the financial system to provide credit in support of new investment on the scale necessary to maintain economic expansion is in increasing doubt. ...

Then there are the potentially adverse effects on confidence of a sharply falling dollar, rising energy costs, geopolitical uncertainties especially in the Middle East, or lower global growth as economic slowdown and a falling dollar cause the US no longer to fulfil its traditional role of importer of last resort.

In such an environment, economic policy needs to be governed by the clear and public recognition that restoring the normal functioning of the financial system and containing any damage its breakdown may do the real economy is the central macro-economic and financial challenge facing the US. ...

What concrete steps are necessary? First, maintaining demand must be the over-arching macro-economic priority. That means the Fed has to get ahead of the curve and recognise – as the market already has – that levels of the Fed Funds rate that were neutral when the financial system was working normally are quite contractionary today. As important as long-run deficit reduction is, fiscal policy needs to be on stand-by to provide immediate temporary stimulus through spending or tax benefits for low- and middle-income families if the situation worsens.

Second, policymakers need to articulate a clear strategy addressing the various pressures leading to contractions in credit. .... The time for worrying about imprudent lending is past. The priority now has to be maintaining the flow of credit. The current main policy thrust – the so-called “super conduit” ... has never been publicly explained in any detail by the US Treasury. On the information available, the “super conduit” has worrying similarities with Japanese banking practices of the 1990s that aroused criticism from American authorities for their lack of transparency, suppression of genuine market pricing of bad credits, and inhibiting effect on new lending. Perhaps there is a strong case for it, but that case has yet to be made.

Third, there needs to be a comprehensive approach taken to maintaining demand in the housing market to the maximum extent possible. The government operating through the Federal Housing Administration, through Fannie Mae and Freddie Mac, or through some kind of direct lending, needs to assure that there is a continuing flow of reasonably priced loans to credit worthy home purchasers. At the same time there need to be templates established for the restructuring of mortgages to homeowners who cannot afford their resets, so every case does not have to be managed individually.

All of this may not be enough to avert a recession. But it is much more than is under way right now.

With respect to traditional stabilization policy, monetary and fiscal policy lags are fairly long. Because of that, past policy responses will govern our immediate future - it's too late to do much now - and anything done now to change monetary or fiscal policy won't be felt with any force until sometime in the future. Thus, given the growing uncertainty about the future course of economic growth, effective risk management points toward taking actions today to reduce the potential for a catastrophic outcome of a deep and prolonged recession at some point in the future.

Under this policy, inflation is a risk if the housing crisis does not bring down economic growth after all, but it is changes in expected inflation over the longer term rather than shorter-run changes in actual inflation that cause the most worry. Given that markets anticipate an economic slowdown and expect the Fed to act accordingly and cut rates, I don't think a further rate cut will cause long-run inflation expectations to change to any worrisome degree. However, if the Fed fails to reverse any additional easing quickly should the data begin to show there isn't as much to worry about as we thought, or if the Fed eases in spite of an improved outlook, then I think elevated inflation expectations become more of a worry.

I'm still hopeful the economy can weather this, but hope is no excuse for imprudence.

    Posted by on Sunday, November 25, 2007 at 12:51 PM in Economics, Housing, Policy | Permalink  TrackBack (0)  Comments (19)

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