Unlike some of the other recent hiccups in financial markets, the latest round of investor tumult is leaving economists a bit more apprehensive about the outlook for growth.
Forecasters say the credit-related problems that flared up in earnest this week, driving big price gains for safe harbor investments like government bonds and splattering stock prices, have some room to run before presenting a true threat to what is now a growing economy. That said, unlike the year's other worry spots, namely longstanding problems in the housing sector and in lending to low quality mortgage borrowers, the latest troubles are more deeply rooted and possess greater potency to threaten the overall course of economic events. Should problems in financial markets persist and worsen further, the Federal Reserve will likely decide it has to act by cutting rates, economists said. A seizure of credit markets and a sustained rout in stock prices could cause the Fed to both cut its current overnight target rate of 5.25%, and to pump markets with liquidity, mirroring responses to past financial crises. Such a move would not be a bailout and would be aimed at protecting economic output. It would fall well within the Fed's long-established responses to dysfunctional markets. At the same time, it would upend the long-held view the central bank would keep rates steady through the remainder of the year. For now, caution reigns among forecasters. "It's hard to draw any firm conclusions until the dust clears," said Stephen Stanley, chief economist with RBS Greenwich in Greenwich, Conn. He noted that "we've had a lot of false alarms" over the year when it comes to markets, although what's happened this week "doesn't' feel like a blip" that can be easily written off. Indeed, on Thursday the stock market suffered big losses while government bonds enjoyed one of their biggest rally in years, sending yields, which move inversely to prices, screaming down to levels last seen in the spring. Various measures of credit-related markets flashed red, amid a string of news signaling a number of high profile borrowers were running into major issues securing the funds they wanted. Friday's market developments were more sedate, although stocks remain under pressure, with Treasury securities enjoying the related benefits of unnerved investors seeking a safe place to park cash. | |
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| Time Will Tell | |
| Reflecting their caution, economists argue the need for Fed intervention will only become clear over time. The signal won't come from the economic data that usually drive monetary policy. Indeed, even as markets face next week some of the most important economic reports they get in any given month - next week brings jobs and factory activity data - most upcoming numbers will be viewed as belonging to a time now past. Instead, the most important barometer of financial markets' health may prove to be the major stock market indexes. Rather than obscure market gauges pertaining to credit conditions or bond yields, several of the economists argued an index like the Dow Jones Industrial Average is particularly valuable. It aggregates information about financial market liquidity, and it is an important signal for the general public. "I wouldn't tie a specific level of the Dow to a Fed move," said Jonathan Basile, economist with Credit Suisse. "I think it would have to be a pretty significant move in financial markets that would really put into question the viability of and confidence in the Fed's outlook," he said. Ethan Harris, chief U.S. economist with Lehman Brothers, said thus far the type of borrowing that's been scuttled or complicated by the markets' troubles isn't that important a contributor to overall growth. But if what's happening now persists over the next several weeks, the story could change. "The main thing to worry about is confidence," Harris said. "Does the sell off in capital markets start to affect business and consumer confidence?" To know, "the stock market is the key," because it is "the most important linkage into the economy," he said. "At this stage, you have to be worried we are in the early stages of a major financial event," even as it is far from certain that is actually what's happening, Harris said. What economists have in mind are the dark days following the collapse of hedge fund leviathan Long Term Capital Markets in 1998. Its size, coupled with a series of adverse global financial developments, begat a seizure of bond markets and prompted the Fed to cut interest rates, in an ultimately successful attempt to contain the damage. No one is saying they are expecting a replay of that situation, but few saw the 1998 storm advancing, either. While Fed officials have not commented on recent days' troubles, they have by and large been upbeat about the economy and the state of financial markets in comments given over recent weeks. Matters related to subprime lending have been downplayed by Fed officials for a long time now. A speech last week by Federal Reserve Bank of Chicago President Michael Moskow noted that markets have effectively dealt with recent problems. "A number of large hedge funds have collapsed recently," the soon-to-retire official said, adding "the financial markets absorbed these failures with negligible consequences for the broader economy." The Fed remarks, joined with the economic outlook, suggest policy makers will be reluctant to respond to market trouble, especially since they are still struggling with what the consider to be problematic inflationary levels. | |
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| A Silver Lining? | |
| If the damage ultimately remains relatively contained, the markets tribulation may prove a welcome development in the view of Fed policy makers. After all, some of the Fed's leading lights, Vice Chairman Donald Kohn, New York Fed President Timothy Geithner, along with Moskow, have for some time expressed puzzlement that markets had been priced for such a low level of risk. "On one level, the Fed is probably not at all upset at what they are seeing" given their apprehension about risk levels, Stanley said. "As long as this (sell off) is rational and orderly, I think the Fed is happy," he said. Whether things stay that way remains to be seen, and is the key to what the Fed's next step is. | |
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