Fed Walks Economic Tightrope

Inflation concerns vs. housing and credit crises put the Fed in a tricky position.
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The markets aren't sure whether to buy the idea that the U.S. economy is heading toward recession.

It's hard to blame traders when economists and the

Federal Reserve

are so divergent about the economic future. Wednesday may bring some enlightenment in the form of the Fed's beige book, its intermeeting report on the state of the economy.

On the strong side, analysts expect third-quarter growth to be revised to around 5% on Thursday. Job growth has remained sturdy despite a second leg down in the housing market and financial market turmoil that's gripped the second half of the year. And Fed speakers have been cautiously trying to bat back expectations for more fed funds rate cuts.

Fed in a Jam?

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On the weak side, economists note that there is more than $200 billion worth of adjustable-rate mortgages set to reset at higher rates next year on the heels of the biggest drop in residential real estate in decades.

"We're in a high-risk situation, probably one major shock away from recession," says Ethan Harris, chief economist at Lehman Brothers.

It's hard to know what the shock might be, however, given some confusing market responses lately. Tuesday the stock market rebounded sharply, and bond prices fell after a panicky Monday that sent yields in the Treasury bond market to multiyear lows and the stock market into official "correction" territory. The shift came despite a report of plunging consumer confidence and a Goldman Sachs research note suggesting that the economy is in for a nasty slide.

Likewise,

Citigroup's

(C) - Get Report

new $7.5 billion infusion by the investment arm of the Abu Dhabi government boosted the market but did little for Citi's shares, which gained just 52 cents, or 1.7%, to $30.32 on the day.

Goldman predicted that the housing market's decline puts the risk of recession at 40% to 45%. Goldman's report says the Federal Reserve will have to cut the fed funds rate by 1.5% to 3% within the next six to nine months to stave off a recession. Goldman also believes unemployment will rise to 5.5% from its current historically low level of 4.7%. The bank also notes that if a recession does take hold, U.S. home prices will fall 30% from their peak, and if there is no recession, just 15%.

The report comes on the heels of a second wave of credit market seizures that have left the markets for mortgage-backed securities and related structured products nearly at a standstill. The damage has sent financial stocks into a tailspin, as shares of some of the hardest hit, such as Citi,

Countrywide Financial

(CFC)

and

E*Trade

(ETFC) - Get Report

, are down 45%, 79%, and 78%, respectively, this year.

Goldman slashed its ratings on a number of industries that are sensitive to economic growth, including the auto sector, airlines, hotels, trucking, and human resources and temporary staffing companies. Goldman recommended investors seek the safe haven of tobacco companies in case of recession.

While there is a growing number of analysts and economists in Goldman's camp, there are still some concerned that record-high commodities prices -- gold is now above $800 an ounce, vs. close to $600 in January -- a feeble dollar and relatively high-risk premiums on inflation-protected bonds point to enough risk of inflation that the Fed should err on the side of caution when it comes to rate cuts.

At two ends of the spectrum are Nouriel Roubini, chairman of RGE Monitor and professor at NYU's Stern School of Business, and Michael Darda, chief economist at MKM Partners. Roubini has believed since 2006 that the economy is slipping into a recession.

Darda is a self-described economic optimist who believes the U.S. economy may be headed for a slowdown or even stagnant growth. But he worries that a cycle of Fed easing could have some dangerous inflationary consequences. He recoils from the notion that the economy is screeching toward recession, defined by many economists as two consecutive quarters of declining economic output.

In some ways, both may be right. The economy could well enter into a deep cyclical slowdown without stock prices plunging much further from here.

Darda believes a recession is already priced into stocks, and that valuations in the stock market are much more depressed relative to bond prices than the markets have seen in recent downturns.

With a 10-year bond yield of 4%,

S&P 500

profits would need to slide 36% to equalize valuations, according to a version of the Fed model. That would be the biggest profit rout in four decades.

Roubini argues that the credit crunch is back with a vengeance after seeming to abate in September following action by the Fed to lower the cost of borrowing and pump cash into the market.

It's a problem he sees getting worse, not better, as the economy enters a vicious cycle. The liquidity crisis will likely cause investors and institutions to unload assets at fire-sale prices. That would dampen the "real" economy as lending standards would tighten and consumers would ratchet back their spending amid rising energy prices.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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