Business Outlook January 10, 2008, 5:00PM EST

The Fed May Have to Play Catch-Up

Rising joblessness suggests the downdraft from the credit crunch is spreading, and the central bank will have to slash rates more aggressively to avoid a nasty recession

By James C. Cooper

It looks as if the Federal Reserve is crawling out of the frying pan and into the fire. Under heavy pressure from the credit markets, the central bank has been scrambling to ease liquidity strains. So far, those actions are showing good results. Now, though, with recession starting to look ever more likely, the heat under policymakers is coming not just from Wall Street but from Main Street and Capitol Hill. The Fed now faces one very pointed question: Have its efforts to protect the economy from the credit turmoil that flared up last August been too little, too late?

The December labor market report was a shocker, especially the jump in the politically sensitive unemployment rate, to 5%, from 4.7% in November and from 4.4% in March. That rise may be signaling that the impact of credit strains, on top of the housing slump and soaring energy costs, is spreading. Historically, it's rare for the jobless rate, a broad measure of economic performance, to rise as much as it has in recent months without the economy being in a recession.

A severe recession would be especially dangerous in the current financial climate. Tighter credit is already partly to blame for fading growth. A full-fledged contraction in economic activity that hammers profits and adds to job losses would intensify the crunch by causing credit quality among businesses and consumers to deteriorate even more. The housing slump would go from bad to worse, with additional negative consequences for home demand and prices. All this is why the Fed will most likely drop its baby-step approach to rate cutting at its Jan. 29-30 meeting and slash rates by a half point.

Up to now, policymakers have approached credit market strains and economic weakness with two different sets of tools. For the market woes, instead of just cutting rates, they have opened up innovative avenues for banks to borrow from the Fed, such as the new Term Auction Facility, which has been successful at easing the squeeze on short-term funding needs.

By early January, rates on interbank borrowing and asset-backed commercial paper (ABCP) had fallen sharply, and the volume of ABCP ticked up for the first time since August. The moves have also allowed banks to bring many assets of uncertain value held in their structured investment vehicles (SIVs) back onto their balance sheets, instead of offering them up at potentially disruptive fire-sale prices.

The Fed has shown a preference to save the broad impact of rate cuts for addressing the economy's ills. Its recent moves have been measured for fear that stronger action would push up inflation. That caution may have allowed credit market woes to infect economic activity more generally.

In a way, rising joblessness gives the Fed leeway to move more boldly, since the inflation potential of tight labor markets had been one of its concerns. Energy costs are another worry, but sharply slower U.S. growth, which implies at least a modest slowdown overseas, will make oil prices at $90 to $100 per barrel difficult to maintain. On balance, the economy appears to be shifting down to a growth rate that is too weak to sustain any upward pressure on inflation.

Job growth, which averaged 97,000 per month last quarter, has already slowed broadly, and it is now too weak to prevent a further rise in unemployment. Payroll gains essentially ground to a halt last month, increasing by a scant 18,000 workers, and private-sector employment actually edged lower. Still, job growth so far does not look recessionary. Consider that in the first three months of the 1990-91 and 2001 recessions, payrolls fell 335,000 and 374,000, respectively.

Aggressive policy easing by the Fed, along with the growing possibility of fiscal stimulus from Washington, will go a long way to insure against a nasty recession. Right now, though, a "growth recession," as economists call it, in which the economy doesn't contract but grows too slowly to prevent rising unemployment, seems about the best outcome to hope for.

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