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Fed/IMF worry that US may see ‘severe recession’

Currencies, Economic growth, Financial Events, Leverage, Oil markets
By Paul Hodges on 13-Mar-2008

The Financial Times this morning reports that the US Fed fears that ‘the economic downturn in the US could turn into a deep and protracted recession of the kind that plagued Japan’. Clearly based on interviews with senior Fed officials and other policymakers, the two articles (one for the European edition, and one for the US) provide a remarkable insight into the Fed’s current thinking:
• There is a real fear that the US may face a ‘lost decade of growth’ similar to that experienced by Japan after its property bubble burst in the early 1990’s. The Fed believes it can avoid this disaster, but only because ‘it will do whatever it takes to avert such an outcome’.
• It believes that banks will have ‘to recapitalise and write down the value of home loans’. The IMF’s no 2 official, John Lipsky, yesterday added that ‘governments might have to intervene directly with taxpayers money to shore up the financial system’.
• It is concerned that ‘over-extended consumers could start to pull back’, due to rising unemployment, falling house prices and financial market problems. If consumers stop spending and instead start to save (as is normal in a downturn), then a ‘severe recession’ could occur.
• It also acknowledges that inflation risks may impose ‘constraints’ on what the Fed can do.

With investors rushing into inflation-protected bonds, to seek protection from higher commodity prices and currency turbulence, the chief economist at the Bank for International Settlements (the central bankers bank) said yesterday that current difficulties ‘now seem as great today, if not greater, than at any other time in the post-war period’.

Lawrence Summers, former US Treasury Secretary, also spells out policymakers worst nightmares in the article:

• “A vicious liquidity cycle – in which asset prices fall, people sell and therefore prices fall more.
• A Keynesian vicious cycle – where people’s incomes go down, so they spend less, so other people’s income falls and they spend less.
• A credit accelerator, where economic losses cause financial problems that cause more real economy problems.”

Alan Blinder, former Fed vice-chairman, summed up the dangers as follows: ‘What worries me is the prospect of a protracted period of subpar growth’. And he added that the US ‘economy faced super-headwinds because of dysfunctional financial markets’.

From a chemical industry perspective, the only prudent course is to batten down the hatches still further. The Fed has been very slow to recognise the real problems that have developed in financial markets since August. Their liquidity injections, loan facilities and interest rate cuts have all been treating symptoms, not causes. I fear that we may have a very bumpy ride for the next few months.