The credit crisis is worsening, deepening the recession

The Bear Stearns liquidity debacle, and the Fed's temporary bailout response, is just the latest episode in the ongoing credit crisis saga. The credit markets are in for more unwelcome surprises as the financial excesses of recent years further deflate both a broad array of financial institutions and the economy. Expect more financial institution asset write-downs and capital losses. These losses are already approching $300 billion. That will squeeze credit availability further, despite additional agressive Fed easing. The consequence of the credit crunch will be a deeper and prolonged recession, which is just barely beginning. Indeed, the now developing recession is likely to rank among the worst of the post-World War 11 period.

The Fed is doing the right thing to provide a 28-day line of credit to Bear Stearns through JP Morgan Chase. The abrupt failure of a major Wall Street firm due to inadequate liquidity would further erode shaky market confidence in the stability of the financial system. This temporary reprieve buys time for Bear Stearns to find a more permanent solution, including negotiating a sale to potential buyers, reportedly including JP Morgan Chase.

There is no doubt that Bear Stearns was imprudent in its financing of the sub-prime fiasco as well as in other questionable activities. But its culpability is far from unique. And therein lies the challange for the Fed in attempting to soften the blow to the economy in the collapse of a financial house of cards that was created, to be blunt, out of sheer lunacy. Warren Buffet aptly described the financial innovation that built these crumbling assets as "weapons of maas destruction". And so they have become.

The Fed in its meeting next week is likely to cut the funds rate target from its current 3.0% level to at least 2.5%, and perhaps to as low as 2.0%. The report that consumer prices were unchanged in February, both overall and excluding food and energy, gives the Fed lattitude to ease more agressively next week. That increases the chances of a cut to 2.25% or 2.0%. But even a 2.0% funds rate will not be suffient to stem the credit crisis. The Fed will, in due course, ease still further, probably in April.

The Fed will be forced by dire financial and economic consequences to eventually return to a 1.0% funds rate despite the potentially adverse impact of Fed easing on the dollar and inflation fears. There are a number of reasons for this obvious Fed choice. The credit crisis and recession are far greater near-term dangers than inflation. Furthermore the recession will eventually supress inflation. The February unchanged CPI performance is undoubtedly a near-term aberration, not an early sign of that eventual development. Admittedly, Fed easing and for a time an accompaning declining dollar will be raising import prices. But that inflationary process will only persist until the US and global recession gains sufficient force to reduce global demand and price pressures. Indeed, inflation is a lagging response and is likely to remain subdued for a considerable length of time even after the US economy is in a cyclical recovery. Moreover, the dollar will eventually stabilize and strengthen as the recession turns global, particularly as the US economy bottoms out and prospects for a US recovery improve.

One key to the end of the recession is for a bottoming out of housing prices. Given the sizable inventory of unsold homes, the still rising foreclosure rate, more mortgage resets to come and reduced mortgage credit availability, home prices seem far from their bottom. Indeed, there could be as much as a 25% nationwide peak to trough decline in home prices, or roughly twice the drop thus far. Similarly, the declines in equity prices also have much further to go, despite the potential for at times even explosive bear market rallies. Equity market forecasts are notoriously inaccurate. Nevertheless, considering the projected severity of the recession, equity indices may also have thus far only fallen half way to their ultimate lows. Philip Braverman