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Comment: Fannie-Fred may stump slump but feed inflation

The massive increase in state control, by a pro-capitalist US administration,
has provided limited relief only to the financial system. Lehman Brothers has
filed for bankruptcy and Merrill Lynch is being taken over. Other major players
are under threat. It would be wrong to assume that all the potential casualties
would be bailed out.

Rescuing Fannie and Freddie increases the risk of fiscal profligacy, with
negative longer-term implications for the credit rating of US government debt
and inflation. But the move reduces the threat of a slump, at a time when
recession remains a more severe risk than higher inflation.

With oil prices falling sharply since mid-July, to a level below $100/barrel,
and with Chinese inflation falling, there are realistic hopes that inflation in
the US and Europe would peak in the next two to three months. This would make it
easier for the major central banks to cut interest rates.

Rates
Expectations have changed most dramatically in the US. Following
stronger-than-expected second quarter US growth, which contrasted sharply with
outright GDP falls in Japan and the eurozone, the markets started to predict
increases in the Fed funds rate. But, with the US unemployment rate rising in
August to a five-year high and with house prices continuing to fall, earlier
optimism has given way to renewed concerns that US prospects would worsen.
Consequently, many analysts are now predicting an early cut in the US Fed funds
rate to 1.75%.

The European Central Bank continues to maintain a hard line. But an early
shift towards an easier stance is likely, given the realistic possibility that
eurozone GDP will fall again in the third quarter and push the economy into
technical recession. We expect a cut in the key interest rate to 4% in the next
three to four months.

The UK is also moving towards an early cut in rates to 4.75%. While
sterling’s weakness causes problems, the UK economy’s weakness will probably
force policy easing.

Currency
In the currency market, the dollar remains strong. Though prospects have
worsened, US growth is set to be stronger than in the eurozone and Japan. At
least temporarily, the dollar is again a surprising safe haven.

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