Problematic Credit Risks

By:  Dr. Charles Lieberman

Date:  8/18/2008

The economy continues to muddle along. Second quarter GDP will be revised significantly higher, even as job losses and the June surge in energy costs hurt household income and spending. But it is the ongoing restraint from poor credit availability that threatens to undermine the economic outlook and has some forecasters expecting very little growth in the second half of the year. The Fed needs to improve credit availability, or any pick up in economic activity will remain tenuous.

The economy is holding together, despite major crosscurrents. The surge in crude oil prices in June was truly a major adverse event that greatly weakened consumer spending that was already under intense downward pressure. Households reacted quickly to rising energy costs, curtailing spending on autos and light trucks. Businesses reacted by cutting back production and inventories. A sharp rise in exports was a saving grace.

The weakness in housing and inventories set the stage for a better second half, especially if the increase in oil prices in the first half of the year are reversed in the coming months. Housing starts are approaching a bottom and will exert less of a drag on the economy over the balance of the year. Inventories need to be rebuilt. Exports are likely to remain on a solid upward track. This scenario would be very comforting, if not for the restraint coming from the credit markets, which remain a major concern. Risk spreads have not narrowed and banks have restricted credit availability. Mortgage rates have actually increased. These developments could derail recovery.

It is clear that Fed officials understand the issues and their public comments focus more on the downside risks to the economy than on inflation concerns. This is the correct priority order. While core inflation is above the Fed's policy objectives, the indirect effects of surging energy prices surely accounts for some of that increase. Moreover, labor costs remain well contained. Therefore, it is very likely that inflation, both total and core, will moderate in the coming months. So, the Fed should focus on the downside risks to the economy. Despite its effort to improve credit availability, major problems remain and these could keep growth weak or push the economy into recession. There has been some speculation the Fed could reduce interest rates. (Market sentiment swings wildly; it hasn't been more than several weeks since the market was priced for multiple rate hikes in 2008.) Rate cuts are unlikely, but more progress is badly needed for credit flows to improve.

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