Page last updated at 01:22 GMT, Wednesday, 30 April 2008 02:22 UK

Can the US economy be revived?

Analysis
By Steve Schifferes
BBC News economics reporter

Fed chairman Ben Bernanke
The Fed watches inflation risks, fuelled by oil prices and dollar weakness
The US central bank, the Federal Reserve, is poised to cut interest rates again, while the first payments in $100bn (50bn) in tax rebates are being sent this week to help revive the US economy. But have they done enough to avoid a recession?

The extent of intervention in the US economy since the credit crunch began in August has been both swift and unprecedented.

The US central bank, the Federal Reserve, has been particularly aggressive in cutting interest rates from 5.25% to 2.25%.

The US government moved quickly during the winter to pass an emergency stimulus package, with cash rebates to individuals and tax breaks for businesses.

The US economy has expanded for the last six months at annual rate of just 0.6%.

The Fed has also lent billions of dollars to the banking sector to avoid a financial meltdown, including $29bn in government guarantees to keep investment bank Bear Stearns from collapsing.

Financial pain

There is no doubt that the Fed's actions have reduced the chances of a financial meltdown.

Citigroup sign
Citigroup, the US's largest bank, has lost billions

They have allowed all the major financial institutions - which include investment as well as commercial banks - to borrow from a $100bn short-term fund set up to by the Fed.

This has eased their short-term liquidity problems, but it is not clear that we have reached the end of the write-offs from sub-prime and other credit losses.

So far, only around $250bn of the $1 trillion in credit losses estimated by the IMF has been announced.

And, as the IMF has said, it will take some years for the banks to rebuild their balance sheets, during which time they will be more cautious in lending as well as hiring.

That means the financial sector is likely to play a smaller role in the overall economy in the next few years.

Housing slump

The greater risk aversion of the banks is shown by the fact that 30-year mortgage rates have not moved down in line with the Fed funds, and are still over 6%, despite the very sharp rate cuts.

US house prices

This means mortgage lending is now more profitable for banks, and that people in negative equity will find it more difficult to borrow.

The slump in housing values is beginning to affect not just sub-prime borrowers, but prime mortgage holders too.

The closely watched Case Schiller house price index for the 20 major metropolitan areas is now falling at an annual rate of 12.7%, and that rate is accelerating.

Mark Zandi, of Moodys.com, estimates that a 20% drop will put millions of homeowners into negative equity.

The overhang of new construction, with 11 months inventory of unsold homes, makes it difficult to see any recovery in house prices in the near term.

The housing slump is hitting hardest the areas where population and house prices are growing the fastest, such as southern Florida, Arizona, Nevada, and southern California.

But there has been little agreement in Congress as to how much relief to give to homeowners whose properties are now being repossessed in increasing numbers.

The main thrust has been to try and get mortgage lenders to make voluntary arrangements with creditors to delay repossessions, with only limited success.

Recession fears

The housing slump directly impacts on the real economy because of the "wealth effect" - people are more prepared to borrow if they believe they have become richer as a result of the rise in house prices.

A man counting US dollar bills
Will people actually spend the tax rebates?
Now that prices are falling, equity withdrawal through refinancing mortgages is no longer possible, and that is likely to counteract the effects of the temporary tax rebates.

This raises questions about how effective the $100bn stimulus - about 1% of the US economy, and 2% of disposable consumer income - will be?

That depends on how quickly consumers will spend the windfall.

In 2001, consumers spent about 20% to 40% of the tax rebates within three months of receiving them, and 60% within six months.

However, Paul Ashworth of Capital Economics argues that this time, consumers are likely to be even more cautious.

Consumer confidence is at a record low, and borrowing much higher, so many people may choose to repay debt rather than spend.

In addition, the effect of high oil prices on the price of petrol - which has reached record levels - may add about $35bn to consumer costs this quarter, wiping out one-third of the rebate.

Two out of the three main candidates for the presidency are calling for a temporary abolition of Federal petrol taxes over the summer to help ease this burden - although many economists argue this would merely encourage excess consumption.

Inflationary pressures

While both fiscal and monetary policy are providing only limited help for the US economy, there is not much scope for further action on either front.

The fiscal stimulus package doubled the size of the US government's budget deficit, just as the economic slowdown is likely to reduce tax revenues.

And while the Fed rate cuts have lost some of their impact on the real economy, base rates are already at or below the rate of inflation.

With both oil and food prices still spiralling across the world, the Fed will have to move cautiously from now on to limit inflationary expectations and prevent further speculation in the commodity markets.

That also means stabilising the falling dollar, which has been adding to inflationary pressures, and has been hit by the low US interest rates.

For the first time, policymakers in the world's largest economy are realising their limits.




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