Gloom over US economy 'unwarranted'

Financial markets have descended into a major funk in the last two weeks, driving key stock indexes to their lowest levels in more than a year.

But some analysts say the action in stocks and bonds is overstating the chances of grave trouble in the economy.

And they contend the Federal Reserve, Congress and the Bush administration are being goaded by markets to take economic-stimulus measures that may be costly, excessive and even unnecessary.

"The administration, Congress, the Fed and the day traders on Wall Street all seem to be in panic mode," said Allan Meltzer, a veteran economist and Fed-watcher at Carnegie Mellon University in Pittsburgh.

To be sure, perhaps the majority of economists would argue that it's better for policymakers to be safe than sorry with their responses to the housing market slump and the risks it poses to the broader economy.

Yet despite the slowdown in business and consumer activity in recent months, there is no consensus that the economy is heading for a recession, usually defined as a contraction lasting at least six months.

In its latest report on regional trends in the economy, the Fed said on Wednesday that the expansion continued in late November and December, albeit "at a slower pace".

In a Bloomberg News survey early this month, 62 economists projected on average that the economy would grow at a 1.5 per cent annual rate in the first half of this year, less than half the pace of recent years but still positive.

And there has been some good news for the economy amid the slowdown. For example, 30-year mortgage rates have dropped below 6 per cent to the lowest level in more than two years, a boon for many people hoping to take advantage of falling home prices.

But on Wall Street the gloom has just thickened in the new year. Major stock gauges continued their slide this week with the broad Standard & Poor's 500 index falling 0.6 per cent to 1,373.20, its lowest since November 2006.

All of this smacks of deepening pessimism over the economy, which some analysts say is unwarranted.

"This is a classic overreaction," said David Kelly, market strategist at investment firm JP Morgan Funds in New York.Markets, he noted, have a history of wild mood swings that often are dead wrong in what they purport to say about the economic outlook.

One issue now, Kelly and others say, is whether the Federal Reserve risks being trapped by crumbling markets into making bigger interest rate cuts than it might like. The Fed has cut its benchmark short-term rate by a full percentage point, to 4.25 per cent, in three moves since mid-September.

Some bond market investors in recent days have said they expected the Fed to make a bold rate cut, perhaps as much as 0.75 of a point, at its January 29th-30th meeting to show a commitment to staving off recession.

But does the economy need dramatically lower rates to stay on a growth track?

One of the main concerns of policymakers has been a risk of a worsening credit crunch stemming from the housing market's woes, as lenders that have suffered heavy losses because of rising mortgage delinquencies cut back on extending loans.

On Tuesday banking titan Citigroup said it lost a record $9.8 billion (€6.7 billion) in the fourth quarter largely because of write-offs related to troubled mortgage securities.

There have been some signs, however, that efforts by the Fed and other major central banks have been calming credit-market fears. Since early December the rates bank charge each other for short-term loans have dropped significantly in the so-called Libor (London Inter-Bank Offered Rate) market, which is closely watched for signs of financial-system stress.

"Some of what they've done is clearly working," said Diane Swonk, an economist at investment firm Mesirow Financial in Chicago, of central banks' efforts.

She also noted that cuts in the Fed's benchmark rate typically take six to 12 months to work their way into the economy, which means the most recent three cuts would be expected to buttress business and consumer activity in spring and summer.

If stocks keep dropping and investors continue to rush into government bonds, however, the Fed may have little choice but to respond with bolder rate moves in the next few months, analysts say.

Still, there is a risk that lower interest rates, combined with federal tax cuts or other stimulus measures by Congress, could lead to greater inflation pressures by providing too much juice for the economy, according to Meltzer and other economists.

The Fed already is facing a troubling inflation picture: the US consumer price index rose 4.1 per cent last year, the largest annual increase in 17 years, because of escalating food and energy costs. Inflation pressures also have risen in Europe and elsewhere.

Of course, if a serious recession takes hold, deflation, rather than inflation, could become the big worry.

But if the economy skirts recession and picks up speed in the second half of this year, deeper Fed rate cuts in the short term could get the blame if faster growth also is accompanied by rising inflation. -