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Economics Weekly - Will the sub prime credit crisis cause a US recession? Weekly economic data preview - US Fed rate cut looks inevitable

Economics Weekly  17 September 2007


Will the sub prime credit crisis cause a US recession?


Fed to cut interest rates...

The US Fed decision on whether to lower interest rates will be one of the most eagerly awaited in years. Will the Fed cut its key official interest rate in reaction to the turmoil in credit markets and the risk it poses to an already fragile housing market? The Fed faces some key challenges and criticisms, almost no matter what it does. Our analysis in this Weekly shows that there is some scope for the Fed to cut interest rates based on economic trends, but only modestly. Further, cutting rates runs the risk of being seen to bail out financial markets from their own mistakes and so underpinning risky action in future, the so called moral hazard issue. Indeed, there is an argument that part of the reason for the current crisis is precisely that US interest rates were kept too low for too long and cut too quickly and too often whenever it looked as if the financial sector was in difficulty.


...but only modest cuts are likely...

The weakness of the US housing market is persisting for rather longer than the Fed thought likely earlier in the year. But it is no worse than it was at its lowest point in late 2006. Chart a shows that US new home sales and existing home sales have been choppy but are not consistently falling. The key question is whether the current credit market turmoil will lead to a renewed fall in home sales, since this does seem possible there is a clear reason for the Fed to cut interest rates at its 18th September monetary policy meeting. But how far can the Fed cut interest rates? Looking at chart b, it does appear that mortgage applications and mortgage approvals are recovering, which implies that the fall in home sales may well be limited; credit constraints are not strangling the market and that lower prices may already be encouraging new buyers. This may limit the negative impact of the housing downturn on the rest of the economy.


However, data for retail sales and manufacturing output show that although retail sales are still holding up well, year on year growth in manufacturing output is slowing, albeit with rising capacity utilisation, which stood at 82.2% in August (a level at which the Fed does not usually cut interest rates). So, on the basis of consumption and manufacturing activity, there is also some scope for a modest easing of US interest rates, with the risk that otherwise the credit crisis could hit business and consumer confidence. However, there is little evidence so far that after an initial fall consumer confidence is weakening any further (September data for University of Michigan confidence were up on August) and business confidence remains strong. But the risk of things going wrong may prompt the Fed to take out some insurance by cutting official interest rates modestly. Chart d show shows that gdp growth has weakened in 2007 but remains well in positive territory, with consumer spending growth the main driver. What is underpinning this? Chart e shows that unemployment in the US is still very low, albeit with a modest rise in 2007. In addition, wage inflation is strong, at 3.9% in the year to July. Both of these factors are supporting consumer confidence and household spending.


...because the inflation profile is not as weak as many suppose

However, chart f shows that the Fed funds rate could be cut slightly, so long as the economy remains weak. But any cut should only be modest, of the order of 0.25%, and possibly a total of 0.5%, and even then the Fed is running risks with inflation. The final chart shows that despite all of the market assumptions about weak inflation, producer prices are still relatively high, consumer prices are close to the rate of growth of earnings and hence the scope for lowering Fed funds is less than is predicted in the futures market, which are looking for 4.25% by June 2008. This seems highly unlikely to us. We would look for at most another 0.25% ease in October (after one this month to 5%) taking rates to 4.75%, but then rising in 2008 as the housing market crisis abates and the credit crunch eases. With a strong global world economic background, we look for the US economy to rebound in 2008 and for growth to be of the order of 2.8%, especially with an easing in Fed funds this year. This implies that the dollar could also rebound, equities could rise and bond markets may sell off, but this is a story for later in 2007. At present, the Fed may find that is has disappointed market expectations with a modest cut and equities could sell off and bond markets rally. The Fed does not have as much room for flexibility as the financial markets are assuming. After all, the current scope to cut rates stems from a fall in consumer price inflation engineered by the Fed, but this has occurred precisely because of higher interest rates and weaker growth.


Trevor Williams, Chief Economist


Weekly economic data preview


US Fed rate cut looks inevitable


The US interest rate decision on Tuesday understandably takes centre stage in what is also an important week for economic data. The Fed is expected to cut its target rate to 5%, possibly 4.75% according to the futures market, after keeping it steady at 5.25% since June 2006, primarily reflecting fears that the ongoing dislocation in money markets is now spreading to the real economy. Looking at the key data released this week, the focus will be on inflation and housing market figures in the US and UK and the German Zew survey on Tuesday. The minutes of the BoE MPC September meeting are published on Wednesday (we expect a unanimous vote for no change) and the BoJ meets to decide interest rates early on Wednesday, where we expect the target rate to be maintained at 0.5% for the seventh straight meeting.


• While a reduction in the Fed target rate for overnight loans is widely expected, there remains considerable uncertainty about its size and any other possible measures - such as a further cut in the discount window rate - the Fed may also introduce, and so the final decision and accompanying press statement on Tuesday could elicit significant market reaction. We look for a cut to 5% in the target rate this month, followed by another 0.25% reduction in October. While a larger cut on Tuesday is clearly possible, we believe the Fed will be hesitant to do more than 0.25%, particularly since it is unclear how effective any policy measures will be in resolving what appears to be primarily a transparency problem or information gap in credit markets, which is likely to take time to work through before confidence returns. We believe interbank money market rates are likely to remain in excess of base rates for at least the remainder of this year.


US data this week should also highlight why the Fed will remain cautious about aggressively cutting its target rate. Although core CPI inflation has slowed from its brisk pace earlier this year, it still remains above the Fed's implicit target range of 1-2%, despite the slowdown in economic growth and weak housing market. Facing the prospect of faster economic growth next year and high oil prices (reflecting robust global growth), the Fed would have clearly liked more confirmation of moderating inflation before cutting interest rates. We forecast the annual core rate was steady at 2.2% for the fourth consecutive month in August. Recent evidence from the ISM surveys and Beige book also showed the impact on the real economy from the problems in the credit market has been limited so far. This should be confirmed by both the Empire and Philly manufacturing surveys this week. We believe there is a real risk that the Fed will be forced into raising interest rates next year, possibly sharply. However, housing market data this week may show continued weakness, with both housing starts and building permits at decade lows in August.


• There are also some important UK economic releases this week, which should provide further support to the view that Bank rate has peaked. Although the minutes of the BoE MPC September 5/6 meeting are expected to show a unanimous vote to maintain Bank rate at 5.75%, the comments may highlight increased concerns about the need for further tightening. This may be reinforced by data on Tuesday showing annual CPI inflation remained under the 2% target for a second month in August, possibly even below the 1.9% rate in July. Recent data from the housing market have shown a sharp downturn in sentiment and we expect this to be reflected in weaker consumer spending in the months ahead. On Thursday, we look for the first monthly fall in retail sales since January, possibly by up to 0.3%, pushing the annual growth rate back below 4%. M4 money supply data will also attract attention, particularly given the ongoing problems in the credit market, and an easing in the annual rate is expected.


• It is a quiet week for key data from the euro zone, with the German Zew survey on Tuesday the highlight. We look for a sharp fall to -15 in September, from -6.9 in August, reflecting the ongoing nervousnesss in European credit and debt markets.


Jeavon Lolay, Senior Economist


Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


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