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Congress and Wall St. pivot on economy

Times Staff Writer

Is a recession a serious risk -- or is it mostly in Wall Street’s mind?

Financial markets have descended into a major funk in the last two weeks, driving key stock indexes to their lowest levels in more than a year.

But some analysts say the action in stocks and bonds is overstating the chances of grave trouble in the economy.

And they contend that the Federal Reserve, Congress and the Bush administration are being goaded by markets to take economic-stimulus measures that may be costly, excessive and even unnecessary.

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“The administration, Congress, the Fed and the day traders on Wall Street all seem to be in panic mode,” said Allan Meltzer, a veteran economist and Fed watcher at Carnegie Mellon University in Pittsburgh.

To be sure, the majority of economists might well argue that it’s better for policymakers to be safe than sorry with their responses to the housing market slump and the risks it poses to the broader economy.

Yet despite the slowdown in business and consumer activity in recent months, there is no consensus that the economy is heading for a recession, usually defined as a contraction lasting at least six months.

In its latest report on regional trends in the economy, the Fed said Wednesday that the expansion continued in late November and December, albeit “at a slower pace.”

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In a Bloomberg News survey early this month, 62 economists projected on average that the economy would grow at a 1.5% annual rate in the first half of this year, less than half the pace of recent years but still positive.

And there has been some good news for the economy amid the slowdown. For example, 30-year mortgage rates have dropped below 6% to the lowest level in more than two years, a boon for many people hoping to take advantage of falling home prices.

But on Wall Street the gloom has just thickened in the new year.

Major stock gauges continued their slide Wednesday, with the broad Standard & Poor’s 500 index falling 0.6% to 1,373.20, its lowest since November 2006.

The Dow Jones industrial average also gave up more ground, losing 34.95 points to 12,466.16. It is down 6% since the year began -- nearly wiping out its entire gain for 2007.

The U.S. market’s downbeat mood has spread overseas in recent weeks, hammering foreign stocks as well. Japan’s main market index is down 12% this year while the German market has fallen 7.4%.

Some investors who are fleeing stocks are buying government bonds for their perceived safety -- accepting extremely low yields on the securities, including a mere 3% annualized yield on five-year U.S. Treasuries, the lowest since 2004.

All of this smacks of deepening pessimism over the economy that some analysts say could feed on itself.

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“This is a classic overreaction,” said David Kelly, market strategist at investment firm JPMorgan Funds in New York.

Markets, he noted, have a history of wild mood swings that often are dead wrong in what they purport to say about the economic outlook.

One issue now, some economists say, is whether the Federal Reserve risks being trapped by crumbling markets into making bigger interest rate cuts than it might like.

The Fed has cut its benchmark short-term rate by a full percentage point, to 4.25%, in three moves since mid-September.

What’s more, Fed Chairman Ben S. Bernanke last week promised “substantive” further rate cuts to help the economy. He is likely to give the same message when he testifies today before the House Budget Committee.

Despite Bernanke’s latest promise on rates, however, “the Fed has not been effective at restoring investors’ confidence,” said Diane Swonk, chief economist at investment firm Mesirow Financial in Chicago.

Some bond market investors in recent days have said they expected the Fed to make a bold rate cut, perhaps as much as three-quarters of a point, at its Jan. 29 and 30 meeting to show a commitment to staving off recession.

But does the economy need dramatically lower rates to stay on a growth track?

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One of the main concerns of policymakers has been the potential for a worsening credit crunch stemming from the housing market’s woes, as lenders that have suffered heavy losses because of rising mortgage delinquencies cut back on extending loans.

On Tuesday, banking titan Citigroup Inc. said it lost a record $9.8 billion in the fourth quarter, largely because of write-offs related to troubled mortgage securities.

There have been some signs, however, that efforts by the Fed and other major central banks have been calming credit-market fears. Since early December the rates banks charge one another for short-term loans have dropped significantly in the so-called LIBOR market (which stands for London Inter-Bank Offered Rate), which is closely watched for signs of financial system stress.

“Some of what they’ve done is clearly working,” Swonk said of central banks’ efforts

She also noted that cuts in the Fed’s benchmark rate typically take six to 12 months to work their way into the economy, which means the three most recent cuts would be expected to buttress business and consumer activity in spring and summer.

If stocks keep dropping and investors continue to rush into government bonds, however, the Fed may have little choice but to respond with more aggressive rate moves in the next few months, analysts say.

Some economists say the Fed should pull out all the stops, because they believe recent data suggest a recession is underway. They point to the government’s report of weak job growth in December and a 0.4% drop in retail sales for that month.

The employment report, in particular, “confirmed our suspicions that the economy was transitioning into an official recession towards the end of last year,” David Rosenberg, an economist at Merrill Lynch & Co., said in a recent report.

Still, there is a risk that lower interest rates, combined with federal tax cuts or other stimulus measures by Congress, could lead to greater inflation pressures by providing too much juice for the economy, Meltzer and other economists said.

The Fed already is facing a troubling inflation picture: The U.S. consumer price index rose 4.1% last year, the largest annual increase in 17 years, because of escalating food and energy costs. Inflation pressures also have risen in Europe and elsewhere abroad.

Of course, if a serious recession takes hold, deflation, rather than inflation, could become the big worry.

But if the economy skirts recession and picks up speed in the second half of this year -- and faster growth is accompanied by rising inflation -- the Fed could be blamed for overreacting with rate cuts. That was the rap on the central bank after it held its key rate at 1% from mid-2003 to mid-2004.

Despite Wall Street’s hunger for more action by Washington, “we really do risk going too far,” Swonk said.

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tom.petruno@latimes.com


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