The Federal Reserve, facing its first big test in the financial markets under Chairman Ben S. Bernanke, said yesterday the widening credit crunch on Wall Street poses only a minor threat to economic growth.
The central bank left interest rates unchanged, saying inflation remains a greater threat and that it expects “moderate” growth to continue because gains in jobs and incomes remain solid despite the credit-induced housing recession.
Investors on Wall Street, hoping for a bailout, did not like the Fed’s statement of tough love at first, sending the Dow Jones Industrial Average down 100 points. But they later appeared to accept the Fed’s expression of concern, and the Dow recovered to end the day with a 36-point gain.
“The downside risks to growth have increased somewhat,” the central bank said in a nod to many on Wall Street who are calling for interest rate cuts to enable people to refinance and get out from under problem loans. But the Fed indicated that the economy’s threshold of pain has not been reached despite the failure of dozens of mortgage companies weighed down by defaulted loans this year.
The Fed historically has been most concerned about the solvency of major banks that are insured by the federal and state governments. All of the lenders that have gone under, including New Century Financial Corp. and American Home Mortgage Investment Corp., were private companies without government backing. Moreover, none was large enough to have a significant impact on financial markets.
The Fed’s assessment reflects what private economists are saying about the fallout from the credit crunch that started with subprime borrowers early this year but has spread to homebuyers with better credit as well as riskier business loans.
“We do not see the Fed reacting to any market disruptions, unless of course there are grave and ominous issues regarding liquidity,” said Richard Yamarone, economist at Argus Research Corp. “Bailing out the financial markets or those engaged in the ’don”t ask, don”t tell” mortgage lending game is not in the Fed”s mandate.”
If a liquidity crisis develops, “then the Fed will quickly ride to the rescue — all market participants appreciate this,” Mr. Yamarone said. “Right now however, there isn”t any real reason” for a rescue. “The markets are functioning properly … and any losses incurred to the banking system as a result of the hedge fund losses are likely to be limited to just those players engaged in risky investing.”
Moody’s Investors Service told clients yesterday that the largest U.S. banks face modest risks and manageable fallout from mortgage defaults, and it does not expect any spectacular failures.
Wall Street’s investment houses, however, financed many of the problem loans and face greater risks. Standard & Poor’s said last week it is considering a downgrade of Bear Stearns, the hardest-hit. Moody’s said it declined to take action on any of the Wall Street firms in part because so little is known about their mortgage liabilities.
“Market disturbances have had little-to-no ripple effect on the macroeconomy” so far and “probably haven’t even been noticed by consumers,” Mr. Yamarone said.
“Don’t bet against the resilience of the American consumer. The consumer hasn”t stopped spending in 62 consecutive quarters, and with full employment there”s very little reason to expect that string to change.”
A report from the Labor Department yesterday highlighted the Fed’s concerns about inflation pressures emanating from the tight job market, where wage gains have been gathering speed. It showed a pick-up in labor costs to 4.5 percent in the last year even as productivity growth — which offsets labor costs — downshifted to 0.5 percent in the first half of 2007 from 1 percent last year.
“This productivity report definitely confirms the inflation fears of the Fed,” said Harm Bandholz, economist with UniCredit Markets. The lower trend in productivity growth suggests that the economy’s average growth rate has downshifted to about 2.5 percent, he said, and it might be “dangerous” for the Fed to allow growth any higher than that.
Some analysts noted that the market reaction to the Fed’s statement yesterday was limited in part because most investors are assuming that the Fed will move to cut interest rates later this fall, despite its vow to wipe out inflation.
Richard Berner, economist at Morgan Stanley & Co., said the Fed will not change its stance quickly, and will need further proof that inflation is declining before it will consider cutting rates. But he said many on Wall Street are having trouble telling the difference between a credit crunch and a “bumpy repricing of risk.”
“The Fed appears to believe, as we do, that repricing of risk in markets has not morphed into a credit crunch,” he said. “The downside risks to the economy of sticking to an inflation bias seem small — smaller than the moral hazard resulting from a market bailout.”
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