REVIEW & OUTLOOK
Credit Correction
Will the Fed and the Democratic Congress tempt a larger stock market selloff?
Any equity selloff as large as yesterday's will produce a multitude of explanations. Among other culprits, we heard about "overbought" Chinese stocks that were due for a correction, a weak durable goods report, the Kabul explosion aimed at Vice President Dick Cheney (see below), and former Federal Reserve Chairman Alan Greenspan for declaring Monday that a "recession" was possible later this year.
Our own "whodunit" contribution would point to the mortgage-related markets, which sold off nearly as much as stocks. This reflects the cracks appearing in the housing credit markets, especially in subprime loans but with some damage up the income chain as well. Along with emerging markets such as China, this is where the excesses have been most notable. And when Adam Smith does a house cleaning like yesterday's, he sweeps the dirtiest corners first.
The question is whether this is a forecast or merely a correction. As evidence of the latter, we'd point to Mr. Greenspan, whose Monday remarks seem to have been over-interpreted as a recession prediction. In the same discussion, we're told, he called the world economy "benign and stable." Nonetheless, we'd also note that Mr. Greenspan's predecessor as Fed Chairman, Paul Volcker, didn't muse about recession dangers after he left office in the 1980s. He didn't want to complicate Mr. Greenspan's monetary task at the time.
We also wouldn't make too much of one month's decline in durable goods. These are notoriously volatile, especially in transportation, which was way down in January. Today's report on fourth quarter GDP is also widely expected to be revised downward from the original 3.5%. But much of that revision may be due to an inventory work off, which bodes better for growth going forward. The labor market remains strong, if slowing from the rapid pace of job growth in 2006.
The bigger risks continue to be political and monetary. The era of tax cutting has ended with the arrival of the Democratic Congress, and other policy errors are possible. As for the Fed, we'd feel better if current Chairman Ben Bernanke had been running a tighter monetary policy for the last year; it might have left him with more policy room if the economy does turn sour. As it is, any easing now runs the risk of a dollar rout, which could lead to an even larger loss of confidence and selloff.
The current problems in the housing credit markets owe a great deal already to the Fed's mistake in keeping monetary policy too easy for too long during the late Greenspan era. We now have to ride them out, and Mr. Bernanke shouldn't make them worse with a panicky, premature easing.
