Sunday, September 14, 2008

Bernanke May Be Wrong: Next Rate Move Might Be Down (Update1)

By Rich Miller


Sept. 12 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke and his fellow policy makers agreed at their August meeting that their next move on interest rates would probably be up. They may turn out to be wrong.

Inflation looks likely to ebb, thanks to falling commodity prices and contained labor costs. The U.S. economy, meanwhile, may be set to take another lurch down as consumer spending gives way and the credit crunch intensifies with the plunge in Lehman Brothers Holdings Inc.'s shares.

``If the consumer balance sheet starts to unwind quickly, you'd get another disinflationary force and then the Fed would be brought back into play with lower rates,'' says Mohammed El- Erian, co-chief executive officer of Pacific Investment Management Co. in Newport Beach, California.

Bernanke and his colleagues are likely to hold their benchmark rate at 2 percent when they meet Sept. 16 and may keep it there until 2009, trading in federal funds futures indicates. Still, the odds of a rate cut by year-end have been growing. Futures trading shows more than a 40 percent chance of a December reduction, up from zero odds at the beginning of September.

Traders increased their bets after government figures today showed sales at U.S. retailers unexpectedly dropped in August and a bigger-than-forecast decline in wholesale prices signaled inflationary pressures may ease.

San Francisco Fed President Janet Yellen left open the possibility of a rate cut in comments to reporters after a Sept. 4 speech in Salt Lake City. ``There is some chance'' of easing credit ``if things start going seriously wrong,'' she said.

Policy Decision

She made clear, though, that she agreed with her fellow policy makers, who ``generally anticipated that the next policy move would be a tightening,'' according to the minutes of the Fed's last meeting on Aug. 5.

If the Fed instead ends up lowering borrowing costs, it wouldn't be the first time Bernanke and his colleagues have been forced to shift their stance from fighting inflation to supporting growth. When the credit crisis first struck in August 2007, the Fed cut its discount rate on loans to banks just 10 days after declaring that inflation was its overriding concern.

Investors have remained on edge since then, even after the Fed-assisted takeover of Bear Stearns Cos. in March and the rescue of Fannie Mae and Freddie Mac this month. Shares in Lehman Brothers dropped more than 70 percent this week as the firm reported a record $3.9 billion loss for the third quarter and concern mounted about its capital levels.

`Feedback Loop'

The big risk is what some at the Fed have called an ``adverse feedback loop'' as the credit crisis and the weak economy aggravate each other. Now, officials also fear that another spiral could take hold as the U.S. housing collapse and credit crunch weaken economies overseas, in turn curbing U.S. exports.

``The balance of risks in the American economy is now towards contraction and a vicious cycle in which declining economic performance exacerbates financial strains, which feeds back to hurt the economy,'' Harvard University professor and former Treasury Secretary Lawrence Summers said in congressional testimony Sept. 9.

Jan Hatzius, chief U.S. economist at Goldman, Sachs & Co. in New York, reckons that the credit squeeze will bring the economy to a halt in the fourth quarter of this year and the first quarter of next, after growth of 2 percent this quarter.

``The headwinds pushing against the economy look to be a good bit stronger than those experienced in the early 1990s,'' when the country last faced a credit crunch, Boston Fed President Eric Rosengren said in a speech Sept. 3.

`Tapping the Brakes'

Wachovia Corp. of Charlotte, North Carolina, the fourth- largest U.S. bank, is ``tapping the brakes'' on lending as credit losses mount, Chief Executive Officer Robert Steel told investors Sept. 9.

Debt-laden consumers appear particularly vulnerable as house prices continue to fall and unemployment rises. Credit- card payments 30 or more days overdue rose to 4.7 percent of total card debt in the second quarter, the highest level in 4 1/2 years, according to the Federal Deposit Insurance Corp.

The Fed reported in its latest regional economic survey, released Sept. 3, that consumer spending was slow in most of the country, ``with purchasing concentrated on necessary items.'' Nondiscretionary outlays -- including rent, taxes, food and fuel -- accounted for a record 57.8 percent of expenditures in July, up from 56.3 percent a year earlier.

Even some well-off consumers are feeling the pinch. Cie. Financiere Richemont SA, the Geneva-based maker of Cartier necklaces and Piaget watches, said Sept. 10 that the lower and middle range of the luxury-goods market in the U.S. is facing ``difficult'' market conditions.

Threat to Exports

The spread of the weakness abroad is threatening to undercut one of the U.S. economy's few strengths: exports, which accounted for virtually all of the growth in second-quarter gross domestic product. On Sept. 10, the Japanese government said the world's second-largest economy is ``deteriorating,'' and the European Commission forecast a recession for Germany.

``Not only is the U.S. in a recession, but the rest of the world is slowing down,'' Ford Motor Co. Chief Executive Officer Alan Mulally said in a Sept. 8 speech. ``I've never seen anything quite like it.''

The global slowdown does have one silver lining: It's sapping demand for everything from oil to soybeans, dragging down their prices and taking the edge off inflation. The Reuters/Jefferies CRB Index of 19 raw materials has tumbled 25 percent since hitting a record in July. Crude-oil prices dropped close to $100 a barrel this week from a high of $147.27 just two months ago.

`Very Hopeful'

``I am very hopeful that inflation will come down quite substantially,'' Yellen said in a Sept. 5 speech, pointing in particular to the drop in commodity prices.

Consumers' troubles will also help to temper inflation -- which ran at a year-over-year rate of 5.6 percent in July, the fastest pace in 17 years -- by making it tougher for companies to raise prices. Some may even be forced into reducing them.

Medford, Oregon-based Harry & David Holdings Inc., which markets gift baskets and other products, said Sept. 7 that it is cutting shipping charges to its customers by as much as one- third from last year as it prepares for what analysts expect will be a tough holiday-selling season.

``With the risk of inflation steadily disappearing and the economic risk rising, the Fed will cut rates,'' says Ethan Harris, chief U.S. economist at Lehman Brothers in New York.

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