Federal Reserve warns about crisis on housing market

Federal Reserve is sure that the housing slump will drag on well into next year as credit problems linger. But it is not so apparent how it will deal with the crisis.

Photo: Federal Reserve warns about crisis on housing market

In recent speeches, Fed policymakers have stressed that the country is going through a period marked by a high degree of economic uncertainty. Given that, Bernanke and his fellow policymakers have kept their options open about the Fed's next move.

Since cutting a key rate last month for the first time in just over four years, Fed policymakers have pledged to "act as needed" to keep the economy growing and inflation in check. That broad pledge has left the door open to, among other things, another reduction to its key rate, holding that rate steady or taking more narrowly tailored action by slicing its lending rate to banks.

"We will need to be nimble," said Donald Kohn, the central bank's No. 2 policymaker.

With the housing slump deepening, credit troubles persisting and Wall Street on edge, a growing number of investors and economists believe the Fed will lower its key rate.

The federal funds rate probably will be cut by one-quarter percentage point to 4.50 at the end of a two-day meeting Wednesday, these analysts predict. The federal funds rate affects many other interest rates charged to individuals and businesses and is the Fed's most potent tool for influencing economic activity.

"I'm becoming more inclined to think the Fed is going to cut rates," said Stuart Hoffman, chief economist at PNC Financial Services Group.

Others, however, think the Fed will leave rates unchanged. They worry that galloping oil prices could spread inflation through the economy. Oil prices briefly spiked above $93 a barrel on Monday.

If the funds rate is lowered, commercial banks' prime lending rate - for certain credit cards, home equity lines of credit and other loans- would drop by a corresponding amount, to 7.50 percent.

"Things are in motion. There is a lot more velocity in terms of developments in the markets and that makes it harder for the Fed to stay on top of things," said Brian Bethune, economist at Global Insight. He's in the camp expecting another rate cut.

While not sending a clear signal on their next move, Bernanke and his colleagues, in remarks over the past month, have been consistent in their assessment that the housing slump and credit crunch pose the biggest risks to the country's economic health.

The tricky part for the Fed is getting a handle on how these problems will affect buying and investment decisions by individuals and businesses - major shapers of overall economic activity.

"It remains too early to assess the extent to which household and business spending will be affected by the weakness in housing and the tightening in credit conditions," Bernanke said recently. "The ultimate implications of financial developments for the cost and availability of credit, and thus for the broader economy, remain uncertain," he said.

So far, consumers appear to be holding up to the strains. But fresh pressures on businesses have emerged.

Many big companies have trimmed sales expectations and banks are taking a financial hit. The largest and second-largest banks, Citigroup and Bank of America,eachreported big drops in third-quarter profits, as did Wachovia. Bank of America also announced it was slashing 3,000 jobs.

Foreclosures on homes have soared and lenders have been forced out of business - casualties of the housing and mortgage meltdowns.

The big worry is that individuals and businesses will cut back spending and investing, throwing the U.S. economy into a recession.

"These are uncertain times," Janet Yellen, president of the Federal Reserve Bank of San Francisco, said earlier this month. "Any forecast and any analysis of events should be made with a great deal of humility about its correctness," she said. "And, that's why I am keeping an open mind about prospects for the future."

Fed Governor Frederic Mishkin, in a speech last week, said the Fed's moves so far have helped ease the credit situation and improve investor confidence. But he added: "Market functioning has certainly not yet returned to normal" and "it is still too early to judge" whether the Fed's actions will prove successful.

In the risk-management playbook the Fed used in the past, the central bank charts a course of action based on the scenario that would bring about the most damage to the economy - even if the possibility of that scenario occurring was remote. For instance, if the worst-case scenario is a serious economic slowdown or a recession, even if the probability were relatively low, then a Fed rate cut would be warranted.

"I do not see this extreme outcome as likely. But it is one of those high cost outcomes that we should guard against," Charles Evans, president of the Federal Reserve Bank of Chicago, said last week.

Evans said the impact of financial problems on economic activity "are hard to predict." When the United States was suffering through its last global financial crisis a decade ago and there were forecasts of doom and gloom, the U.S. economy ended up logging brisk growth topping 4 percent.

Economic growth in the July-to-September quarter is believed to have moderated to a pace of around 3 percent, which would still mark a solid showing especially given that problems in housing and credit market intensified during the period. The government releases its estimate of third-quarter economic growth on Wednesday.

Analysts, however, predict economic growth probably will slow sharply to about half that pace - 1.5 percent - in the current October-to-December period as the toll of housing and credit woes makes consumers and businesses more cautious.

The unemployment rate, now at 4.7 percent, is expected to climb to nearly 5 percent by the end of this year or early next year as the pace of economic activity shifts to a slower gear.

Former Federal Reserve Chairman Alan Greenspan last week said the chances of a recession are "definitely less than 50-50" but cautioned that great uncertainty remains. The credit markets, he said, are still operating in a "state of fear."

While there have been some improvements in the functioning of financial markets since August, "strains ... persist even now," Fed Governor Randall Kroszner said last week. William Poole, president of the Federal Reserve Bank of St. Louis, called the financial situation "fragile."