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Fed faces risks of inflation, recession

By's John W. Schoen.
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Tuesday’s aggressive interest rate cuts by the Federal Reserve were intended to calm the financial markets and help give a boost to a sagging U.S. economy battered by an ongoing recession in the housing industry.

It will take months — or longer — to know if the decision was the right one. In the meantime, the Fed still faces risks no matter what move it makes next.

With a bolder move than many Fed watchers had expected, the central bank slashed a half-percentage point from its target federal funds rate — used as a benchmark for a variety of short-term consumer and business loans, including the prime rate. The first cut in four years brought the fed funds rate down to 4.75 percent, and banks followed by lowering the prime rate to 7.75 percent.

Fed Chairman Ben Bernanke and his colleagues also slashed a half-point off the so-called “discount rate” on direct loans to banks.

Financial markets and bankers cheered the move. The Dow Jones industrial average rose 335 points for its biggest gain in five years; prices of short-term Treasury securities also surged, reducing market interest rates.

“God bless the greatest central bank in the world,” said Jon Evans, chief executive of Atlantic Central Bankers Bank, which serves community banks in five states. “This is great news for the economy and the consumer.”

Many Fed watchers had been expecting a more modest quarter-point cut. In announcing its decision the Fed said that “will act as needed to foster price stability and sustainable economic growth."

Those twin goals — containing inflation while dodging recession — highlight the balancing act the central bankers are trying to pull off. A course of limited or gradual rate cuts might not have been enough to keep the slowing U.S. economy from being dragged into a downturn by the housing recession.

On the other hand, rapid, aggressive cuts could spark another round of the kind of easy credit that created the housing bubble — and risk eroding gains in the Fed’s hard-fought battle to keep inflation under control.

For the moment, fears of a housing-lead recession and the potential for more turmoil in the financial markets seem to be governing the Fed’s thinking.

"The tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally," the Fed's rate-setting Open Market Committee said in its statement Tuesday. "Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets."

Even before Tuesday’s meeting, the Fed spent much of August trying to push money into the banking system by encouraging banks to borrow through its so-called discount window. Those moves helped provide some calm from the storm that swept through the financial markets a month ago.

Assessing the health of the economy is probably the Fed’s toughest task at the moment. On Tuesday, the FOMC  got two more pieces of data to chew on before making its latest rate policy announcement. Those two reports provided fresh news from the two fronts of the battle being fought by the Fed — that of keeping the markets and the economy on an even keel without setting the stage for higher inflation.

The Labor Department reported that wholesale prices fell by 1.4 percent in August, led by a big pullback in energy prices. Even without that drop, so-called "core" inflation rose just 0.2 percent for the month.

Meanwhile, the ongoing mortgage mess continued to widen in August. As financial markets remained skittish about the risk of rising defaults, the number of foreclosure filings more than doubled from a year ago and jumped 36 percent from July, according to a RealtyTrac, a Web site that specializes in foreclosures.

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.

“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.