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US recession forces unconventional response

The US economy is now almost certainly in recession. Hopes that other regions
can decouple from the US have dwindled. The credit crisis is very persistent,
and existing policy tools may be inadequate. The major central banks are being
forced to adopt unorthodox methods.

Aggressive Fed interest rate cuts have failed to alleviate the US downturn.
Re-pricing of risk has pushed up interest rates on mortgages and other risky
assets, in spite of lower official rates. House prices are falling and the
labour market and spending are weakening. In February, US jobs fell 63,000, the
biggest decline in five years, while retail sales fell 0.6%. Most analysts
believe that the US is already in recession; the uncertainties relate to its
depth and length.

The global implications are serious. Eurozone and Japanese growth are slowing
and the weakening dollar will further damage their exports. China and India,
though still buoyant, will also have to slow as both are experiencing an upsurge
in inflation and both are taking steps to cool their economies.

The Fed will continue to cut interest rates, in spite of doubts over the
effectiveness of this tool. Forecasts regarding US rates have been lowered. We
expect the Fed funds rate to fall to 1.75% before mid-2008. But the crisis is
deepening. The failure of Carlyle Capital fund signals that not only sub-prime
loans are vulnerable, but also triple-A mortgage-backed securities. The
liquidity crisis engulfing Bear Stearns has forced the Fed to underwrite
emergency support. This came after two huge Fed liquidity injections, totalling
more than $400bn.

Unusually, the Fed has accepted mortgage-backed securities as collateral. If
necessary, the Fed may adopt even more forceful methods, in spite of the huge
risks in terms of moral hazard and inflationary bubbles. Other central banks
have co-operated with the Fed in boosting liquidity, but they are more worried
about inflation and more reluctant than the US to cut interest rates.

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