Fed's Lacker Says Economy Worsening Credit Crunch

By Craig Torres

Nov. 3 (Bloomberg) -- Falling U.S. economic growth and rising unemployment may further erode banks' willingness to lend to consumers and businesses, Richmond Federal Reserve Bank President Jeffrey Lacker said.

``The deterioration of economic conditions is playing a more prominent role in the tightening of credit terms right now than the direct effects of financial market turbulence,'' Lacker said today in the text of remarks prepared for a conference in Jerusalem.

The Federal Reserve, responding to increasing signs of flagging growth, cut the benchmark interest rate by half a percentage point on Oct. 29 to 1 percent, matching a half- century low.

Policy makers may need to cut further if weak growth continues to restrain credit, Fed watchers say. Some 19 of 42 economists surveyed by Bloomberg News expect a reduction of at least a quarter point at the next meeting of the central bank on Dec. 16.

Future rate decisions will depends on ``how the data comes in,'' Lacker said in a questions-and-answers session after the speech. There was a ``distinct shift in the mood'' across the economy in September and ``it's going to take a little while to understand what this translates into in terms of economic activity,'' he said.

`Reasonable' Forecasts

Predictions of an economic recovery next year are ``reasonable,'' Lacker said, adding that policy makers should ensure inflation expectations remain contained when an expansion takes hold.

``As a recovery begins, the path of least resistance is often to hold the policy rate at a low level until it is completely clear that recuperation is complete,'' Lacker said. ``It is crucial that we not allow expectations of future inflation to ratchet higher during this recession.''

The U.S. economy contracted at a 0.3 percent annual pace from July to Sept., the Commerce Department reported Oct. 30, for the biggest decline since 2001.

``It's definitely a recession at this point,'' Lacker said. ``How deep, how steep it's going to be is uncertain. I think it's more likely of a fairly moderate size. I don't foresee a 10-year Great Depression.''

The federal funds rate is ``stimulative,'' financial shocks have dissipated and energy prices are falling, he said.

Housing Drag

Credit-market turmoil may have been intensified by the ``disparate responses'' by government to troubled financial institutions, Lacker said in remarks to the Global Interdependence Center at Hebrew University. Instability in equities and other worldwide markets worsened after the U.S. government decided not to avert a bankruptcy filing by Lehman Brothers Holdings Inc. on Sept. 15.

``Once households are convinced that an end to the deterioration in the labor-market conditions and the fall in equity and home prices is in view,'' consumer spending ``is likely to pickup substantially,'' Lacker said. ``The drag from housing seems likely to lessen in the next year'' possibly reaching a bottom ``around the middle of 2009.''

Unemployment is at a five-year high of 6.1 percent and may rise to 8 percent by the end of 2009, according to Jan Hatzius, chief U.S. economist at Goldman Sachs Group Inc. in New York. Consumer spending fell 0.3 percent in September, the biggest decline in four years, the Commerce Department said Oct. 31.

Mortgage Collapse

``In times like this there is just a wider range of uncertainty,'' said Lacker today. ``Things have to be data- dependent.''

The collapse of the U.S. mortgage market has paralyzed lending worldwide and led to losses and writedowns at financial institutions totaling $686 billion. The Fed financed a $29 billion portfolio of Bear Stearns Cos. securities in March to facilitate a merger with JPMorgan Chase & Co.

The central bank agreed in September to loan as much as $85 billion to insurer American International Group Inc. and the U.S. Treasury seized control of Fannie Mae and Freddie Mac, the largest sources of money for U.S. home loans.

Lacker, 53, said in June that the Fed should set rules and boundaries for its direct loans to avoid provoking more costly risk-taking by financial institutions too reliant on the federal safety net.

Growth Outlook

During recent turmoil, ``market participants have at times faced uncertainty about prospective public sector intervention,'' Lacker said today. Shifting expectations about when the government would let a firm fail ``may have added volatility to financial asset markets that were already roiled by an increasingly uncertain growth outlook.''

The Fed redoubled its support last month to financial markets, agreeing to finance the commercial paper issuance of General Electric Co. and other corporations and help money- market mutual funds raise cash to meet shareholder redemptions.

Lacker placed some of the blame for the mortgage boom on ``official policies aimed at increasing home-ownership,'' which provided ``some positive inducement'' for risk-taking by mortgage lenders. It's also ``plausible'' the Fed left its policy rate too low for too long in 2003 and 2004, he said. The federal funds rate stood at 1 percent even though the economy was expanding.

Inflation expectations will be shaped by the Fed's monetary stimulus and how long ``that stimulus remains,'' Lacker said. A voting member of the Federal Open Market Committee next year, Lacker dissented during the last four meetings of 2006, preferring an increase in interest rates.

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net