Bill Jamieson: Bernanke's over a barrel whatever way he jumps

ANOTHER day, another dollar. Or another two dollars if the flight from the US currency continues much longer. On Friday it hit record lows against the euro and the Swiss franc. Against a basket of major currencies it hit a record low and grazed its biggest weekly loss in more than two years.

This matters, because every downward notch in the dollar fuels an investor scramble into gold (hitting new records), oil (touching $103 a barrel) and commodities such as coffee, soya bean and corn. They have all soared in price in recent weeks, adding to the inflationary pressures building up on the world's central banks.

And it is adding to a mighty policy nightmare for the world's most powerful central banker, Ben Bernanke, chairman of the US Federal Reserve.

The flight from the dollar is driven by market forecasts of another big cut in US interest rates. Two weeks ago the popular expectation was that the Federal Open Markets Committee looked set to chop another 50 basis points off the federal funds rate at its next meeting on March 18. But the chances of a 75 basis points cut are rising. And some are calling on him to slash rates, now at 3%, by a full 100 basis points if America is to be spared its worst recession since the 1970s.

This begs two searching questions. First, can Bernanke dare risk further rate cuts, looking at the effect on the dollar and the big push it gives to inflationary pressures? Consumer price figures for January showed inflation now rising at 4.3%. More worrying is the jump in America's import price index to an annual rate of 13.7%, compared with 'only' 10.7% in December.

The second question is at least as troubling. Can the Fed dare risk not cutting rates – right down to 2% ultimately – if the economy is to avoid a serious recession? For judging by a damning report before the US Congress last week, the country's sub-prime mortgage and housing crisis is set to get worse unless rates are slashed – and quickly.

The report, summarised below, is a chilling description of the scale and depth of America's housing crisis.

What's different from the position four to six weeks ago is that a sense of fatalism is setting in. Last Friday the Wall Street Journal reported that more homeowners are abandoning their homes and their mortgages. "Home prices have fallen so far so quickly that some homeowners in weak markets are concluding that house prices won't recover anytime soon, and therefore they are throwing good money after bad."

Bernanke is under intense pressure to act. But whichever button he hits – cut or no cut – will be the 'wrong' one. Sceptics question what it is that another 100 basis point cut in interest rates can do that previous cuts of 225 basis points have so far failed to achieve. Indeed, given the inflationary consequences of further cuts, the Fed with every further reduction it makes may be condemning America to that worst of all worlds: stagflation.

Despite the Fed's projection that inflation will moderate later this year, all the signs are that it is picking up. Even worse from the Fed's viewpoint is that its belief that slower growth in demand will bring a decline in cost pressures is belied by the fact that construction costs are accelerating, not declining.

Not for more than a decade has there been greater apprehension over the policy impasse that now grips the world's biggest economy.



Bernanke continues to talk to Congress of the need to "act in a timely manner to support growth". Last week he cited dangers of further deterioration in the housing and labour markets and of the continued tightness in credit markets as of particular concern. The fourth-quarter GDP data corroborates Bernanke's concerns on the extent of the slowdown, making it highly likely that the Fed will cut next month.

Central to the Fed's thinking is the latest Monetary Policy Report on developments in the US housing and mortgage markets presented to Congress last week. It makes for chilling reading.

It said sub-prime adjustable rate mortgages (ARMs) account for about 7% of all mortgages outstanding. Delinquency rates on these sub-prime loans began to increase in 2006, and by December 2007, more than one-fifth were seriously delinquent – that is 90 days or more delinquent or in foreclosure.

The continued erosion in the quality of mortgage credit has led to a rising number of foreclosure filings. In fact, they hit a record pace in the third quarter of last year.

In some cases, falling prices may have tempted more speculative buyers with little or no equity to walk away from their properties. Foreclosures have risen most in areas where home prices have been falling after a period of rapid increase. Foreclosures have also mounted in some regions where economic growth has been below average.

Between one million and 1.5 million sub-prime ARMs are scheduled to undergo their first rate reset this year. Even with the recent declines in market interest rates, a notable proportion of those sub-prime ARMs are scheduled to reset to a higher interest rate. According to Wall Street watcher Ed Yardeni, the case for a 100 basis points cut in the federal funds rate is that it would most likely freeze almost all of the resets.

The supply of unsold homes has doubled over the past three years to a 20-year high. A bottoming-out for new home sales and prices does not look likely before midyear at the earliest.

And this sense of deepening crisis in the housing market is spreading to the consumer. Figures last Friday showed spending essentially flat for the second straight month in January. Inflation-adjusted consumer spending has not been so weak since November and December of 2001, when the country was struggling to emerge from the last recession.

But with the dollar in a tailspin, the Fed risks runaway inflation if it opts to cut rates again.