Mon, Sep 03, 2007 page10

• US economist warns of serious risk to economy

  CASE Harvard University's Martin Feldstein says that a sharp reduction in the lending rate could help the economy avoid a very serious negative outcome

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  Harvard University economist Martin Feldstein said the US housing slump threatens a broader recession, and the US Federal Reserve should lower interest rates.

  "The economy could suffer a very serious downturn," Feldstein, head of the group that charts US business cycles, told a Fed conference in Jackson Hole, Wyoming, on Saturday. "A sharp reduction in the interest rate, in addition to a vigorous lender-of-last-resort policy, would attenuate that very bad outcome."

  Feldstein made a case for lowering the overnight lending rate between banks to 4.25 percent from 5.25 percent to cushion the economy from the fallout of defaults on subprime mortgages.

  Fed Chairman Ben Bernanke told the same gathering last Friday that the Fed will do what's needed to stop this month's credit-market rout from ending the six-year expansion.

  Lowering interest rates may result in a "stronger economy with higher inflation than the Fed desires," a situation Feldstein described as the "lesser of two evils."

  "If that happens, the Fed would have to engineer a longer period of slow growth to bring the inflation rate back to the desired level," Feldstein said.

  Some investors speculated that Feldstein was a candidate for Fed chairman before Bernanke was picked to succeed Alan Greenspan.

  Bernanke wasn't in the room for Feldstein's speech, though most other Fed officials were, along with central bankers and economists from around the world who traveled to the annual mountainside conference hosted by the Kansas City Fed bank.

  "Marty is a guy of good judgment," said former Fed governor Lyle Gramley, who attended the event. "Everybody in the room recognizes that. Everybody, including the people at the Fed, will think carefully about what he said."

  The US economy expanded at a 4 percent annual rate in the second quarter, the fastest pace in more than a year, before turmoil in the credit markets forced the Fed to warn in an Aug. 17 statement that risks of slower growth had increased "appreciably."

  Already, some indicators are suggesting a weakening economy. First-time applications for jobless benefits rose to the highest level since April in the week ended Aug. 25.

  Property values in 20 metropolitan areas fell 3.5 percent in June from a year earlier, an Aug. 28 report by S&P/Case-Shiller said.

  Feldstein outlined a "triple threat" from housing: a "sharp decline" in home prices and construction; higher borrowing costs and a "freeze" in credit markets stemming from subprime-mortgage losses; and fewer home-equity loans and refinanced mortgages, leading to less consumer spending.

  Investors expect the Fed to cut the federal funds rate on overnight loans between banks to 5 percent on Sept. 18 and at least another quarter point by year's end. The central bank has left the rate at 5.25 percent since June last year after raising it from 1 percent over a two-year period.

  Gramley, a senior economic adviser at Stanford Group Co in Washington, said he was surprised by the gloominess of Feldstein's 25-minute speech, which capped a conference where many participants were pessimistic.

  Kansas City Fed President Thomas Hoenig, speaking briefly after Feldstein, said the symposium gave him and probably his colleagues "a lot of useful information to use as we deal with some difficult issues that confront us all."

  Earlier in the day, Fed Governor Frederic Mishkin presented a paper in which he said that US banks can cope with "stressful" conditions and that the financial system is in "good health" even with the disruptions of the mortgage market.

  Mishkin also reiterated that policy makers should avoid setting interest rates according to swings in the housing market and respond "only to the extent that they have foreseeable effects on inflation and employment."

  That point was challenged by some participants, including Bank of Israel Governor Stanley Fischer.

  Feldstein had said in an interview last Friday that there is a "significant risk" of a downturn and urged the Federal Reserve to cut borrowing costs.
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