Inflation Pressures Are Easing but Rate Cut Forecast Remains Uncertain

The New Year is beginning where the old one ended -- with uncertainty about when – or whether – the Federal Reserve will begin cutting interest rates.

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If you needed more proof that the financial problems dominating the news are serious – as if the dizzying stock market declines we’ve been seeing aren’t sufficient to make that point – consider the number of analysts from all corners of the political spectrum who are saying that the $700 billion bail-out plan Congress has approved is just a “first step.” A $700 billion first step?

It takes a brave soul and a strong stomach to contemplate what the next step (or steps) might entail or how much they will cost. But it is clear that approval of the troubled asset purchase plan that is to be overseen by the Treasury Department has not done much to calm the teeming financial waters.

After rebounding briefly before the legislation was enacted, on expectations that it would be approved, the stock markets in the U.S. and abroad have been spiraling more or less steadily downward. Analysts attribute that response partly to doubts about the plan, but more to growing concern that America’s problems have morphed into a global crisis that threatens to spin beyond the reach of the government policy makers trying to contain it.

In rapid succession, , Germany, England and Iceland, respectively, have been forced to rescue giant lenders in those countries, the governments of Ireland and Germany have promised to guarantee savings deposits to calm nervous consumers, and on the same day, trading was halted on the major stock exchanges in Russia and Brazil after prices plummeted.

A Frozen Market

The focus of concern in the U.S. is on the credit markets, which have all but ceased to function in anything resembling a “normal” fashion. Illustrating that point, LIBOR (the benchmark for the interest rate banks charge each other for overnight loans) has been rising for several weeks and the spread between LIBOR and the overnight index swap rate continues to widen, indicating an almost total lack of confidence in a market in which confidence is crucial. Short-term loans to businesses in the commercial paper market have declined from $2.2 trillion last summer to $1.6 trillion, falling by more than 9 percent in the past two weeks alone and prompting the Federal Reserve to announce that it will begin buying commercial paper itself —in effect, lending directly to businesses that can’t find the credit they need to fund their operations. Economists have warned that failure to unlock the jammed credit doors will exacerbate a recession that many believe has already begun.

Optimists —a relative term these days – say the bail-out plan will ease these financial market strains – eventually. But critics of the plan continue to question not just how long it will take to kick in but whether it will work at all.

An open letter to Congress signed by 200 university economists and finance professors questions the wisdom of bailing out companies that created the financial mess, and warns that the bail-out may end up doing more to harm the economy in the long term than it will do to help it in the near-term.

Other critics question the theory underlying the assistance program – that having government purchase underwater assets will restore investor confidence in the financial markets. While the government-sponsored auctions of these assets will establish a market price for them, these critics say, there is no guarantee that “market” price will hold and considerable cause for concern that any relief in the credit markets will be minimal and short-term.

‘Catch-22’

Some see a potentially fatal ‘Catch-22’ in the bail-out structure itself. The only way to boost bank capital positions in a significant way, they say, is by paying premium prices for the assets Treasury purchases, but that would also increase the potential cost to taxpayers and delay the ultimate reckoning needed to produce a housing market recovery.

The most serious flaw in the plan, many analysts contend, is that it misses the mark, focusing on assisting financial institutions rather than on dealing directly with the implosion of the housing market that is at the root of their problems. The asset purchase plan “does nothing to stop [the downward spiral] in housing prices resulting from a self-reinforcing cycle of defaults, foreclosures, increasing inventories and declining home sales, economist Martin Feldstein argued in a recent op-ed article in the Wall Street Journal.

“You need to do something to deal with [the housing] problem,” Jonathan Kappell, a professor at the Yale School of Management agreed. Otherwise, he told MSNBC.com, “six months from now, we are going to be sitting here having another debate about the next bailout package [we are going to need].” More next steps to come? Stay tuned. And breathe deeply.