Fed mulls measures to prevent double-dip

Jeremy Torobin

Ottawa — Globe and Mail Update Published on Tuesday, Aug. 03, 2010 7:27PM EDT

The U.S. Federal Reserve meets next week amid mounting evidence that the world’s biggest economy is slowing and increasing questions about whether new measures are needed to ward off deflation and prevent a double-dip recession.

After expanding at a slower-than-estimated pace between April and June, the U.S. economy carried precious little momentum into the second half of the year, three reports released Tuesday showed.

Taken together, the data paint a worrisome picture of indefinitely tepid growth that in a worst-case scenario could spur a widespread drop in prices and another slump. As Fed chairman Ben Bernanke and his officials prepare to meet on Aug. 10 in Washington, weighing heavily on their minds will also be this Friday’s employment report from the Labour Department. Economists predict the private sector added a paltry 90,000 jobs in July, not enough to keep the 9.5-per-cent unemployment rate from rising as the U.S. Census Bureau cuts thousands of temporary workers.

“There’s a lot going on behind closed doors right now,” Eric Green, chief U.S. rates strategist for TD Securities in New York, said in an interview. “In terms of what happens next week, I just don’t think that the Fed has come full circle on this yet. But the risks are mounting that they’ll have to do something.”

Contracts to buy currently owned homes plunged 2.6 per cent in June from the previous month, data from the Washington-based National Association of Realtors showed Tuesday, a further sign that a now-expired homebuyer tax credit was artificially propping up the market. Manufacturing, which effectively led the U.S. out of its worst downturn since the Depression, is cooling again, with orders at American factories dropping 1.2 per cent in June, a Commerce Department report showed.

Perhaps most telling, consumer spending – which makes up about 70 per cent of the economy – was little changed in June, incomes didn’t grow for the first time since September, and Americans’ savings rate rose to 6.4 per cent, the highest level since June of 2009.

Higher savings bode well for the future, in that American consumers are repairing their balance sheets after years of overspending. For now though, consumers’ skittishness is feeding into businesses’ investment and hiring plans and also causing a dip in a key stock market that had been buoyed last month by optimism about companies’ earnings.

“The whole policy mix to contain the recession was designed to promote borrowing and to promote spending, and you have very powerful deleveraging forces among households and corporations that are pointing to quite the contrary,” Mr. Green said. “The handoff from government to the private sector, before you even have the withdrawal of all the stimulus, is looking increasingly dicey.”

The Standard & Poor’s 500 declined Tuesday for the for the first time in three days, while currency and bond traders increased bets that the Fed will need to do more.

On top of pledging repeatedly to keep interest rates at rock-bottom levels for an “extended period,” the Fed pumped more than $2-trillion (U.S.) into the economy in the last three years through various measures such as buying mortgage-backed securities. Actions the Fed could take, if deemed necessary, range from implying that borrowing costs could be kept low for even longer, to buying more U.S. Treasuries or mortgage bonds to support the financial system.

There are indications of a growing debate within the Fed about how to jolt the economy.

James Bullard, president of the Federal Reserve Bank of St. Louis and usually an inflation hawk, said in a paper released last Thursday that the Fed’s commitment to keep interest rates near zero could have the opposite of its intended effect, by leading to Japanese-style deflation.

Most of the talk among policy makers at the U.S. central bank in recent months has actually been about when to pull back from measures used to fight the recession. Mr. Bernanke has not indicated whether he favours returning to a more aggressive approach, though he did say this week that economic growth will be “moderate.”

Jennifer Lee, a senior economist at BMO Nesbitt Burns Inc. in Toronto, said she sees little risk of deflation because companies could slash inventories to avoid cutting prices. Like Mr. Green, she said another round of stimulus from the Fed is not imminent, but isn’t out of the question.

“Even fears of a double-dip, I mean, we don’t think that’s going to happen but I wouldn’t completely write it off,” Ms. Lee said in an interview. “Right now we’re in this period where you’re not getting a firm signal on either side from all the economic indicators coming out. It’s almost flat, which is better than going down but we’re not really going anywhere.”