Fed Battles `Big-Time' Economic Erosion With New Cuts

By Rich Miller

Oct. 27 (Bloomberg) -- Less than three weeks after the Federal Reserve's emergency interest-rate reduction was, in the words of its vice chairman, ``overwhelmed'' by the collapse of financial markets, Ben S. Bernanke is about to try again.

The outlook has worsened since the Fed last acted on Oct. 8, and analysts now say the economy may shrink more than 2 percent in the final quarter of 2008, its steepest decline in at least 18 years. ``We're heading south big-time,'' says Lyle Gramley, a former Fed governor who is now senior economic adviser at Stanford Group Co. in Washington.

As a result, Fed Chairman Bernanke and his colleagues may eventually have to drive the benchmark overnight rate close to zero to resuscitate the economy. The next installment comes Oct. 29 when, says Gramley, ``the Fed is going to cut rates a half percentage point.''

That would reduce the central bank's target for the federal funds rate, which commercial banks charge each other for overnight loans, to 1 percent. The official rate hasn't been that low since 2004, and has never been lower since the Fed began trying to control it in the late 1980s. More cuts may follow if the economy doesn't recover.

Bernanke, 54, and his colleagues are carrying out what Vincent Reinhart, former Fed director of monetary affairs, calls a ``great monetary experiment'' in attacking the financial crisis -- and the credit crunch it spawned -- on three fronts: lower rates, increased liquidity and purchases of assets that banks and investors don't want.

A Worsening Economy

So far, they've had limited success in turning things around. In fact, the economy looks to be worsening and may shrink at an annual rate of 2.2 percent this quarter, based on the median of forecasts from 11 top economists in the last two weeks. That would come after a likely 0.5 percent contraction in the third quarter and would be the biggest decline since the fourth quarter of 1990, when the economy shrank by 3 percent.

Fed policy makers are under no illusion about the difficulties they face as the credit squeeze swamps their efforts to aid the economy with looser monetary policy, including the half-point rate cut carried out in coordination with central banks in Europe and Canada Oct. 8.

Referring to that reduction, Vice Chairman Donald Kohn said in a speech in New York a week later that ``the effects of the easier stance of policy on the cost and availability of credit were overwhelmed'' by a further erosion of financial markets.

ECB Cut `Possible'

The European Central Bank, too, may be forced to cut interest rates for the second time in less than a month as the financial crisis intensifies. ``I consider it possible that the Governing Council would decrease interest rates once again at its next meeting,'' on Nov. 6, ECB President Jean-Claude Trichet said in a speech in Madrid today.

In an acknowledgement of the troubles the Fed is encountering, Bernanke last week supported another fiscal- stimulus package and suggested that lawmakers focus their effort on encouraging more lending through guarantees and other steps. The previous measure -- $168 billion mostly in tax rebates -- provided only a temporary boost in consumer spending.

`So Much Damage Done'

``There's been so much damage done,'' says Robert DiClemente, chief U.S. economist at Citigroup Global Markets in New York. ``That's not going to go away quickly.''

Some economists say they fear the crisis has already dealt such a blow to the finances and psyche of consumers and companies that output will collapse in the final months of the year. That's what happened in the second quarter of 1980, when the economy shrank at an annual rate of 7.8 percent after then-President Jimmy Carter instituted credit controls and urged Americans to cut their credit cards in half.

``The turmoil of the past six weeks has the potential to lead to the type of decline in lending that we had back in 1980,'' says Joseph Lavorgna, chief U.S. economist at Deutsche Bank Securities in New York. He forecasts the economy will contract at a 4.5 percent annual rate in the fourth quarter, though he sees it recovering next year.

Mickey Levy, chief economist at Bank of America Corp. in New York, says the U.S. is in for a ``deep'' recession, with the economy shrinking 3.9 percent in the final three months of 2008.

Tough Times

``We are going to have some very tough times,'' Jack Welch, former chief executive officer of General Electric Co., said yesterday on the ABC News ``This Week'' television program. ``The fourth quarter of this year could have negative growth in the 3- to-4 percent range.''

Companies from aluminum maker Alcoa Inc. to Internet giant Google Inc. are reining in spending as the profit outlook dims. Chemical producer DuPont Co. and other exporters are seeing foreign sales slide as economic growth slows overseas. And builders such as Lennar Corp. are bracing for another reduction in their already shrunken market.

At the heart of Bernanke's inability to revive the economy is the credit crunch. Stung by some $430 billion in losses, U.S. banks have been reluctant to lend money -- even after the Fed's rate cuts and measures to inject liquidity.

To help counter that, Bernanke turned to Treasury Secretary Henry Paulson and Federal Deposit Insurance Corp. Chairwoman Sheila Bair for help. In a package rolled out on Oct. 14, they agreed to invest $250 billion of government money in the financial services industry and to back the banks with guarantees.

Libor Slides

Together with similar actions overseas, that has succeeded in making banks more comfortable with lending to each other again. The London interbank offered rate, or Libor, that banks charge each other for three-month loans in dollars slid to 3.52 percent Oct. 24 from 4.42 percent a week earlier.

That doesn't necessarily mean banks will increase lending to U.S. consumers and companies -- in spite of entreaties by Paulson that they do so.

JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said the bank will be more prudent in extending credit. ``If you're not fearful, you're crazy,'' the head of the largest U.S. bank by market value told Wall Street analysts in an Oct. 15 teleconference.

Investors are also being stingy with their money amid fears the economic slump will push many companies into bankruptcy. The extra yield they're demanding over Treasury securities for so- called junk bonds -- those with ratings below investment grade -- stood at a record 16.69 percentage points on Oct. 24. That's almost double the 8.36 percentage-point spread at the start of September, based on Merrill Lynch & Co.'s U.S. High Yield Master II index.

Crunch `Still Here'

``The credit crunch is still here,'' says John Lonski, chief economist at Moody's Capital Markets Group in New York. ``It may have eased a bit but not enough to assure a supply of credit to the private sector that is sufficient to finance a return to passable economic growth.''

St. Louis Fed President James Bullard said the U.S. risks suffering the same fate as Japan in the 1990s when that country's economy stagnated for a decade because of constricted credit.

There is ``some possibility of a very adverse outcome, perhaps similar to Japan's, in which policy initiatives do not work well, the turmoil is exacerbated and the entire economy is drawn into a protracted downturn,'' he said in an Oct. 14 speech.

To try to prevent that from happening, Bernanke may eventually have to cut interest rates to as low as zero percent, just as Japan did in 1999. In fact, then-Fed Governor Bernanke said in 2003 he wasn't opposed to such a move if it proved necessary to aid the economy.

``They're going to cut rates at this meeting,'' says Brian Sack, who worked with Bernanke at the Fed back then and is now deputy director with Macroeconomic Advisers in Washington. ``It's not clear that's going to be the last step.''

To contact the reporter on this story: Rich Miller in Washington rmiller28@bloomberg.net