Wall Street to Fed: Start cutting rates

In part of the continuing folly of forecasting Federal Reserve rate moves, a number of Wall Street economists have spoken out recently on the need for Ben Bernanke to get ready to start cutting short-term interest rates due to the housing slowdown.

So far, it's hard to argue with the Fed Chief - while some economic indicators are flashing yellow, only the housing numbers are currently flashing red. Unlike the chief dismal thinkers at Goldman Sachs, Merrill Lynch, and UBS AG., ever-optimistic economists at the Fed are more likely to expect the next change in color to be back to yellow rather than a brighter shade of red.

Daniel Kruger of Bloomberg reports on the recent developments:

Federal Reserve Chairman Ben S. Bernanke's assertion that interest rates may need to increase to curb inflation is wrong. That's what Goldman Sachs Group Inc., Merrill Lynch & Co. and UBS AG are saying.

While Bernanke warned last month that the odds of worsening inflation have increased, chief economists at the three firms say the worst housing slump in a decade may drive the U.S. economy into a recession and stifle consumer prices. Their chief economists say the Fed will cut its target for overnight loans between banks at least three times this year.

Current Fed funds futures contracts indicate no change to short-term rates through the summer with only a single quarter-point rate cut by the end of the year.

It's all about the housing slowdown - if and when it's going to show up in the overall economy, otherwise known as the question of "spillover", and just how bad it might be.

The conflict boils down to opposing views about real estate. Central bank governors found no evidence that the housing market had affected the broader economy, according to notes of their March policy meeting, released April 11. The National Association of Realtors said last week existing home sales fell 8.4 percent in March, the steepest drop since 1989.

Bernanke is missing "the linkage between residential housing investment and the broader economy," Jan Hatzius, chief U.S. economist at New York-based Goldman, the world's most profitable securities firm, said in an interview. "The housing downturn is of the first order of importance." Hatzius says the Fed will cut rates three times this year, to 4.5 percent from 5.25 percent.

That should be bullish for bonds, says David Rosenberg, chief economist at New York-based Merrill, the world's biggest brokerage firm. He expects 10-year Treasuries to produce the best returns since 2002.
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"The housing-led economic malaise has spread to the business sector," said Rosenberg, who anticipates the Fed will cut its target rate four times to 4.25 percent this year, in an interview. "The economy is still on a slowing trend.''

The U.S. economy grew at a 1.3 percent pace in the first quarter, the slowest in four years, the government said April 27.

"House prices could decline as much as 10 percent," said Maury Harris, chief economist at UBS in New York, in an interview. UBS, based in Zurich, is the world's biggest money manager for the wealthy.

Fed research doesn't agree. The central bank reported "signs of stabilization in housing demand in most regions of the country," according to the April 11 report. "Home-buying attitudes improved and continuing job growth could be expected to support home sales."

Friday's labor report and the possible arrival of the long-awaited "construction employment free-fall" may help to sharpen the jobs debate.

As for inflation, apparently the guys who get paid by the big investment firms could care less - the pay increases their bosses are getting must be many multiples of any measure of inflation and they're probably hoping for some of that to trickle down.

The Fed's preferred measure of inflation, the Commerce Department's price index for consumer spending on items excluding food and energy rose 0.3 percent in February, exceeding the 0.2 percent median forecast of economists surveyed by Bloomberg News. The price gauge rose 2.3 percent from a year earlier, higher than the Fed's comfort level of 1 percent to 2 percent.
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Goldman, Merrill and UBS are among seven of the 21 so-called primary dealers, who trade directly with the Fed, forecasting that the central bank will cut its target rate from 5.25 percent to as low as 4 percent.

They failed to anticipate the Fed in the past. Goldman projected an increase in June 2002 and the central bank ended up cutting rates the next quarter. UBS expected the Fed to double its target by the end of 2003 to 2.5 percent from 1.25 percent. Instead, the Fed reduced borrowing costs to 1 percent in June 2003.

Merrill had forecast in early 2006 that the Fed would end a series of increases when its benchmark reached 4.5 percent. Instead, the Fed boosted rates to 5.25 percent in June.

The track record notwithstanding, the message is clear - start cutting rates.