Smith Faculty Opinion Article	November 20, 2007
By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

An Emergency Interest Rate Cut?

Tuesday, stock markets were lifted on speculation that Ben Bernanke will call an emergency meeting at the Federal Reserve to further cut interest rates. This would be a remarkable turnaround for Chairman Bernanke.

On October 31, the Fed cut the federal funds rate a quarter point to 4.50 percent but essentially said that it would not likely cut rates further. The Open Market Committee stated:

The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth.

Since that time, virtually all the economic news has been bad. Wall Street firms are taking mega write downs on subprime debt, the stock market has tanked, retail and housing sales are in the sink, commercial real estate values are falling, and industrial production is contracting.

It seems the Fed is under pressure every few weeks to change course on policy. After telling us the subprime crisis was under control, both Bernanke and Treasury Secretary Henry Paulson gave speeches on October 15 and 16, explaining why exceptional action would now be required to rework adjustable rate mortgages, reestablish mortgage markets, and ensure general liquidity for the conduct of business.

Which is it Ben: Are we in trouble or arent we?

We are!

The economy is delicately walking along a precipice between much slower growth and a tough recession. If the housing adjustment turns into a route, it will be too late for the Fed to cut interest rates enough to save the economy from a bad episode of stagflation--rising unemployment caused by evaporating household wealth and oil driven inflation.

Yet, the Fed seems at sixes and sevens on all this for four reasons:

First, the Fed has failed to grasp how the damage in the subprime market to the balance sheets of Citigroup, Merrill Lynch and others have damaged fundamental confidence in Washingtons economic management and undermined the resiliency of the U.S. economy.

We have been suffering a crisis of confidence for many weeks, and the Fed doesnt get it. If it did, the Fed would not have precluded further action in its October 31 statement.

Second, unlike the European Central Bank, Fed policymaking primarily focuses on short-term interest rates and not money supply management. In large measure, the U.S. dollars international status as the reserve currency--other central banks use dollar holdings to back up their currencies--makes both the supply of U.S. money and its impact on inflation unstable and difficult to manage.

The practical problem is that money is liquidity, and important segments of the U.S. economy are suffering from a liquidity crisis.

Third, the Treasury and Fed have failed to come to terms with the impact of China on U.S. monetary policy. Chinas policy of undervaluing the yuan and buying massive amounts of dollars and securities, to keep down the prices of yuan and its exports on U.S. store shelves, has significantly unhinged U.S. short-term interest rates from U.S. mortgage and other long-term rates.

Fourth, the Treasury and Fed have failed to come to terms with the corrosive consequences on bond, mortgage and wider credit markets of self dealing at Standard and Poors and other bond rating agencies. No one is going to buy many private U.S. securities as long as rating agencies are paid by Wall Street bankers who appear able to manipulate the process.

In the near term, the Fed needs to help avert complete meltdown in the housing sector by bringing down long rates. It should buy Treasuries on the long end of the yield curve, as well as ensuring adequate and affordable liquidity in the short-term, commercial credit market.

Immediately, the Treasury and Fed should come out for sweeping changes in practices, management and governance at Standard and Poors and other bond rating agencies.

Given the special status bond rating agencies enjoy certifying investments for pension funds and other public purposes, these changes should be more sweeping than those underway at Merrill Lynch and Citigroup. To emphasize the point, the senior management at the rating agencies should not be permitted to leave as cynically enriched as did Stan ONeal at Merrill and Chuck Prince at Citigroup.

Forecasts

Here are my forecasts for upcoming economic data.

Forecast Previous Period

November 21
Initial Jobless Claims 322k 319

Mich Cons Sentiment - Nov (r) 74.5* 75.0
*revised from November 22 mailing

Week of November 26

November 27
Consumer Confidence - Nov 92 95.6
Existing Home Sales - Oct 4.925 5.250

November 28
Feds Beige Book
Durable Goods - Oct 0.4 -1.7

November 29
ADP Employment - Nov 60 106

GDP - Q3 (p) 4.2 3.9
GDP Deflator 0.8 0.8
PC Expenditures 3.0 3.0
PCE Deflator 1.7 1.7
Core Deflator 1.8 1.8

Initial Jobless Claims 322k n.a.

New Home Sales - Oct 0.755m 0.770

Help Wanted Index - Oct 23 24

November 30
Personal Income - Oct 0.4 0.4
Personal Spending 0.3 0.3
PCE Index 0.3 0.2
Core PCE Index 0.2 0.2
Real Personal Spending 0.2 0.1

Construction Spending Oct 0.0% 0.3

Chicago PMI 50.5 49.7

Week of December 3 (preliminary)

December 3
ADP Employment - Nov 55k 106

ISM - Nov 51.2 50.9
ISM - Prices 65.0 63.0

Auto Sales - Nov 16.15m 16.05*
Car Sales 7.54 7.47* Domestic 5.01 5.01* Foreign 5.08 2.46*
Truck Sales 8.61 8.58* Domestic 7.07 7.07* Foreign 1.54 1.52*
*SAAR as published by Motor Intelligence

December 5
Productivity - Q3(r) 5.2 4.9
Unit Labor Cost 0.1 -0.2

Factory Orders - Oct 0.3 0.2
Durable Goods Orders 0.4 -1.7
Nondurable Goods Orders 0.1 1.1

ISM Services - Nov 54.5 55.8
ISM Prices 66 63.5

Pending Home Sales - Oct 85.7 85.7

December 7
Nonfarm Payrolls - Nov 88k 188
Manufacturing Payrolls -10k -21
Unemployment Rate 4.7% 4.7
Average Work Week 33.8hrs 33.8
Hourly Earnings 0.3% 0.2

Consumer Credit - Oct $4.3 b 3.7b

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.