Rate cut alone may not fix economy

McClatchy NewspapersSeptember 20, 2007 

WASHINGTON — Wall Street rallied for a second consecutive day Wednesday, still buoyant over the Federal Reserve’s surprise half-point cut in interest rates, but several leading analysts warn that odds remain high for the nation to fall into recession by next year.

After posting their largest one-day gain in nearly five years Tuesday, stocks kept climbing a day later. The Dow Jones Industrial Average closed up Wednesday by 76.17 points at 13,815.56, for a 3.1 percent gain in two days. The S&P 500 closed up 9.25 points at 1529.03, up 3.5 percent over two days.

While the immediate market reaction to the Fed's dramatic action is encouraging, some analysts fear that problems rooted in shaky housing finance still could squeeze consumer spending and drag the economy down.

Others think that the Fed acted emphatically enough to avoid that. In coming weeks economists will watch home sales, retail sales and especially employment numbers closely for signs of who’s right. All are important indicators of consumer spending, which drives about two-thirds of the U.S. economy.

“There is a significant risk of a recession within the next year," Robert Shiller, one of the nation’s most prominent finance experts, said Wednesday before the Joint Economic Committee of Congress.

“I am worried that the collapse of home prices might turn out to be the most severe since the Great Depression,” said Shiller, a Yale University professor and author who developed one of the leading national indices for home prices.

Home prices could fall another 13 percent in real value by next August in many cities, he said. That's on top of a 6.5 percent decline already from the recent housing-boom peak. This could mean a loss of trillions of dollars in home value, Shiller said. And history shows that consumer spending contracts as home prices fall.

"The Federal Reserve will undoubtedly take aggressive actions, which will mitigate its severity," he said. "But if home price deflation persists or intensifies, they may discover that the Achilles’ heel of this resilient economy is the evaporation of confidence that can accompany the end of boom psychology.”

Other analysts reject the danger.

“Jobs are huge now. That’s what will end this thing,” said James Paulsen, chief investment strategist for Wells Capital Management, an arm of San Francisco-based national bank Wells Fargo & Co.

Unemployment remained low nationwide at 4.6 percent in August. True, the economy did shed jobs in August, the first time that’s happened in four years. But it was a loss of only 4,000 jobs on balance, a statistically insignificant number that was important only because it showed that the economy is slowing.

Paulsen expects that an upward revision to those job numbers or a new month showing strong job growth soon will end recession fears, boost consumer confidence and overshadow news of housing-sector problems.

“You can collapse housing all you want, but unless the consumer goes away, it is not a disaster,” Paulsen said. He thinks that the deep cut in the benchmark federal funds rate Tuesday showed that the Fed recognized “that most of this is a confidence crisis, not a ‘fundamentals’ crisis.”

Others are less sanguine.

The Wachovia Economics Group, part of the Charlotte, N.C.-based national bank Wachovia, warned investors Wednesday that “the damage being done to the housing market is more severe than the recent numbers suggest.”

In a special report, Wachovia economists said Fed Chairman Ben Bernanke and five Fed governors met earlier this month with heads of the nation’s major home builders and may have gotten a peek at sales and cancellation data.

“We believe those data showed a significant deterioration in home sales, which may be evident in next week’s new and existing home sales reports,” the report said, predicting a drop in new and existing home sales of 10 percent or more for August. “Such a drop raises the risks that we will see more spillover into related consumer spending and housing-related services than was earlier anticipated.”

Such a sour outlook might explain why the Fed surpassed most expectations that it would cut its benchmark interest rate by only a quarter point. Most analysts thought that the Fed remained worried about resurgent inflation, which has been moderating but still rose by 2.0 percent over the past year, at the upper edges of the Fed’s comfort zone.

Inflation is the rise in prices across the economy. Tuesday’s rate cut seeks to spark economic activity at a time when many commodities such as copper and wheat are already at record or near-record high prices. Oil prices also set another nominal record Wednesday, when not adjusted for inflation, at $81.93 a barrel, up 42 cents on the New York Mercantile Exchange.

“My feeling is that’s tomorrow’s problem, not today’s, and enjoy it while you can,” said David Wyss, chief economist for the New York rating agency Standard & Poor’s. “I don’t think that inflation is an immediate problem, but down the road the Fed may have to undo some of this.”

The bullish Paulsen shares that view.

“Even if they solve the confidence crisis, they’re going to have to retighten (rates) next year,” he said. “I don’t think you go from ‘the economy is melting’ to ‘it’s overheating’ in a day.”

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