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Published September 3, 2007

FED CONFERENCE

Harvard economist warns of recession, urges rate cut

Key rate slash to shield US economy from sub-prime fallout: Feldstein

(JACKSON HOLE, WYOMING) Harvard University economist Martin Feldstein said that the United States housing slump threatens a broader recession, and the Federal Reserve should lower interest rates.

'The economy could suffer a very serious downturn,' Mr Feldstein, head of the group that charts America's business cycles, told a Fed conference here 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.' Mr Feldstein made a case for lowering the overnight lending rate between banks to 4.25 per cent from 5.25 per cent to cushion the economy from the fallout of defaults on sub-prime mortgages.

Chairman Ben Bernanke told the same gathering on 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 that Mr 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,' said Mr Feldstein, 67, president of the National Bureau of Economic Research (NBER).

Some investors speculated that Mr Feldstein was a candidate for Fed chairman before Mr Bernanke was picked to succeed Alan Greenspan. Mr Bernanke wasn't in the room for Mr Feldstein's speech, though most other Fed officials were, along with central bankers and economists from around the world who travelled 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 recognises that. Everybody, including the people at the Fed, will think carefully about what he said.'

The US economy expanded at a 4 per cent 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 per cent in June from a year earlier, according to an Aug 28 report by S&P/Case-Shiller.

The economy was last in recession from March to November 2001, according to NBER. Mr 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 sub-prime-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 per cent on Sept 18 and at least another quarter-point by year's end. The central bank has left the rate at 5.25 per cent since June 2006 after raising it from one per cent over a two-year period.

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

Kansas City Fed President Thomas Hoenig, speaking briefly after Mr Feldstein, said that 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.

Mr Feldstein had said in an interview on Friday that there is a 'significant risk' of a downturn and urged the Fed to cut borrowing costs. -- Bloomberg