- The Washington Times - Wednesday, March 21, 2007

The Federal Reserve yesterday edged away from its vow to keep raising interest rates to counter inflation, saying that the outlook for the economy has turned mixed as housing comes under renewed pressure from a mortgage credit crunch.

The Fed’s change of heart triggered a rally in financial markets, with the Dow Jones Industrial Average rising 159 points, as investors shed fears that the Fed would endanger growth this year in its drive to reduce inflation from recent elevated levels.

After meeting for two days, the Fed’s rate-setting committee said inflation remains a “predominant policy concern” as it left interest rates alone. But in a change from past statements, the committee said the level of interest rates in the future would “depend on the evolution of the outlook for both inflation and economic growth.”

The Fed signaled it is particularly focused on the housing market by noting the “adjustment in the housing sector is ongoing.” That contrasts with optimism voiced by Fed Chairman Ben S. Bernanke a month ago that the housing recession may have been bottoming out and that increases in defaults and foreclosures seemed confined to the subprime mortgage market.

In the intervening time, the crisis in the subprime market has deepened with major lenders threatened with bankruptcy, and reports have emerged that defaults and foreclosures are spreading to the broader mortgage market. Meanwhile, home builders have reported a “bust” in the usually strong spring market for home sales and have put off construction plans.

“Housing starts are a classic leading indicator of the economy. With a roughly 30 percent drop over the past year, this development is worrisome to the point of threatening Goldilocks,” said Lawrence Kudlow of Kudlow & Co., referring to the “not too cold, not too hot” economic expansion sought by the Fed.

“The subprime mortgage brouhaha may or may not be adding to the slowdown in home construction, but by itself the housing starts decline would be enough to imperil the economic expansion,” he said, noting that sharp housing contractions like the one in the last year have foreshadowed economic recessions in years past.

“The economic story bears very close watching,” he said. “Perversely, we seem to be experiencing subpar growth with some heightened inflationary pressures. The Fed’s statement today hinted at this. They may be caught between a rock and a hard place.”

Richard Yamarone, economist with Argus Research Corp., said Wall Street is wrong to assume that the Fed is close to cutting rates. By saying inflation remains its “predominant” concern, the central bank is signaling it will not cut rates as long as inflation pressures remain strong.

“We believe the Fed is unlikely to slash its overnight target rate due to intensified subprime market concerns, or the jitters in the stock market,” Mr. Yamarone said. “The number of mortgage delinquencies and defaults, while undesirably high, shouldn’t upend the economy.”

Mortgage rates are already at historically low levels, and any Fed rate cuts would do little to reverse defaults that are causing the current credit crunch, while they would do much to fan inflation fires in the rest of the economy, he said.

Among the biggest inflation threats is the pass-through of sharply higher corn prices caused by the massive switch to ethanol use in cars mandated by Congress last year, Mr. Yamarone said.

Because corn is the source of some of the most frequently used sugars and starches, major food companies such as Pepsico, Anheuser-Busch, Coca-Cola, Tyson Foods, Wrigley and Cadbury Schweppes have announced price increases, he said, and restaurant chains are starting to follow suit.

Even the price of leather is rising because of the increasing cost of feeding cattle with corn, he said, leading to price increases for handbags, footwear and apparel.

With the inflation effects of high corn prices just starting to feed through, “there’s no use tossing an accelerant on an already burning flame,” Mr. Yamarone said.

But Bill Gross, investment strategist with the Pimco bond funds, said the building crisis in the housing market threatens the economy’s main engine — consumer spending — and will force the Fed to cut rates deeply.

The housing collapse already has caused consumers to cut back on home equity withdrawals through cash-out refinancings and home sales, which had been a major boon for the economy as it spurred consumer spending throughout the housing boom.

“The Fed will cut rates later this year and their two key criteria will be employment and asset prices,” he said. “With construction laborers about to hit the unemployment lines … an ease as soon as midyear may be in the cards.

“Mortgage credit availability is in the midst of a cyclical squeeze due to subprime defaults and ‘better late than never’ enforcement action by Congress and banking regulators,” he said.

“This should not only continue to floor the housing sector but dampen consumption,” and lead to 2 percent or less growth in the economy.

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