October 15, 2008 / 3:35 AM / 11 years ago

WRAPUP 1-Fed officials see recession risk but no rate cut need

PALO ALTO, California/MEMPHIS, Tennessee, Oct 14 (Reuters) - A pair of top Federal Reserve officials on Tuesday highlighted risks to the U.S. economy from the global credit crisis and liquidity squeeze, but did not hint at more interest rate cuts as a solution.

Janet Yellen, President of the San Francisco Fed, was especially blunt, saying the U.S. economy appeared to be in a recession and would likely contract in the fourth quarter after near-flat growth in the third.

“The outlook for the U.S. economy has weakened noticeably,” Yellen said in a speech to the Financial Executives International’s Silicon Valley chapter in Palo Alto, California.

“Virtually every major sector of the economy has been hit by the financial shock.”

Yellen said while she “strongly supported” last week’s coordinated global rate cut to shore up a teetering world economy, rate cuts were not a cure-all.

“Rate cuts are by no means a panacea, but they do at least partially offset the tightening of financial conditions due to higher spreads, reflecting heightened credit and liquidity risk and a marked increase in general risk aversion,” she said.

James Bullard, St Louis Fed President, also said the Fed should not pin too much hope on monetary policy.

“Overreliance on interest rate policy in this environment does little to solve the problems at hand,” Bullard said in a speech in Memphis, Tennessee.

But the two diverged widely on the inflation outlook. Bullard warned that rate cuts “may cause a new and difficult-to-solve inflation problem” once the current turbulence subsides.

Yellen, often seen as one of the Fed’s more dovish members, said that inflation pressures were fading quickly with plunging energy and commodity prices and the slack appearing in the U.S. economy after nine straight months of job losses that have hurt consumer confidence and spending.

“Some prominent forecasters at this stage are concerned that inflation in future years could decline to levels below what is consistent with price stability,” she said.

Yellen’s assessment was consistent with recent market-based assessments on the inflation outlook. The spread between yields on Treasury Inflation Protected Securities (TIPS) and conventional Treasury notes has collapsed since July .

Neither Yellen nor Bullard are voting members of the Fed’s interest-rate setting committee this year.

The Fed, acting in coordination with other central banks in Europe and Asia, cut interest rates a half point last week to 1.5 percent, and warned that the global credit crisis would impact the economy.

Financial markets data suggest the Fed will lower its benchmark fed funds rate by another one-quarter point at its Oct 28-29 Federal Open Market Committee meeting, to 1.25 percent.

In contrast to Yellen’s assertion of a clear “feedback loop” between the financial market breakdown and weakness in the broader economy, especially as it concerns a slowdown in credit availability, Bullard was less convinced.

“It is far from clear how financial market turmoil of this magnitude will ultimately affect the real economy,” he told the Economic Club of Memphis.

Still, if left unchecked the turmoil could have “severe negative consequences,” he said.

Bullard pinned a “significant” slowdown in growth in the third quarter more on the rapid run-up in energy and commodities prices during the spring and summer, at a time labor markets were also weakening.

Crude oil peaked at about $147 a barrel in July, but has since fallen by about 45 percent to around $79 on concern that the economy could slip into recession.

Bullard said that aggressive action by the Fed and the government — which has pulled together a $700 billion bank bailout package — could ensure that the country escapes the fate of Japan’s “lost decade” of stagnation in the 1990s.

In searching for comparisons to the current episode, Yellen noted that some have termed conditions the worst since the Great Depression of the 1930s.

“But I do not believe that the U.S. economy, in the years ahead, faces a period of economic misery that will begin to rival the suffering associated with that historic economic calamity,” she said.

Bullard said “aggressive government policy” could hold the line at a “sluggish” economy and prevent a protracted downturn. (Writing by Ros Krasny in Chicago; Editing by Tomasz Janowski)

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