Knowledge@Wharton Finance and Investment Research Article

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At the end of October, the Federal Reserve gave the financial markets just what they had been asking for: a 0.25% cut in the federal funds rate. But in early November, stocks plunged and the dollar hit a new low. Applause turned into hand-wringing -- then back to applause as the markets rebounded in the middle of the month.

Why can't the experts make up their minds? Is the outlook good or bad?

It's always difficult to see the future. But according to Wharton faculty, forecasting is particularly hard now because some of the key factors -- such as the credit crunch arising from the subprime mortgage mess, spiking oil prices and the plunging dollar -- have little historical precedent.

The uncertainties have left the Fed sitting the fence. In its October 31 statement, it said it was cutting the fed funds rate to offset the effects of the housing slump. But it also indicated that further cuts sought by the market might not come because of inflation worries. "The committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth," the statement said.

"It makes sense to me," says Wharton finance professor Jeremy Siegel. "I still think the risks of a slowdown are a bit more than that of inflation, but not markedly so. [The Fed] restored an equal balance between the two, and I think that's not unreasonable. I think if it were up to him alone, [Fed chairman Ben] Bernanke would have kept the weakness in the economy as the primary risk. But he had to decide with many others, and so they decided to leave it equal." Like Bernanke and a number of other economists, Siegel expects the U.S. economy to slow down by summer. But he thinks there's only a 25% chance of a recession in the next year or so.

"It's hard to predict," says Wharton finance professor Richard J. Herring. "I think the Fed is genuinely uncertain about this." Herring notes that although the falling dollar makes foreign goods more expensive for Americans, enhancing the inflation threat, it has been a boon to American exporters, since it makes American goods cheap for foreigners.

Meanwhile, many Americans may be feeling poorer, as they see their home values shrink and they spend more for fuel. On the other hand, employment is high, the economy has continued to grow at a decent rate, productivity is up and stocks have racked up nice gains for the year, despite some vicious dips.

It is not clear yet how all this will affect consumer spending, which is key to the American economy, Herring says. "The household sector is the worrisome place at this point. But the short-term statistics are still very strong.... A lot probably depends on what happens in retail in December."

Gregory Nini, professor of insurance and risk management at Wharton, and a former Fed economist, finds the trends encouraging. "I have much less concern now than I did at the end of the summer," he says. Back then, many corporations were finding it nearly impossible to borrow the money they need to grow, thanks to the credit crunch that began with the subprime mortgage crisis. Since then, credit has loosened. Employment numbers also have been encouraging, Nini points out. "The big question now is how the job market will play out, and in particular, how it feeds into consumer spending."

Taking a somewhat more pessimistic view, Wharton finance professor Richard Marston worries that recession is a real threat. The credit tightening that has grown out of the subprime mortgage situation has been worse than many experts had expected earlier in the year, and it is still hard to gauge. If it becomes harder for businesses to borrow, the economy could seriously weaken, he says. "Whether we hit a recession depends on one of two things happening. Either the banks get into enough trouble that they engineer a credit crunch on regular bank lending, which hits the medium and small firms in this country, or the consumer starts to blink. We are weak enough now that either thing could push us into recession."

Unfamiliar Territory

Economists have lots of experience assessing figures for unemployment, inflation, gross domestic product and interest rates, but many are less sure of how to assess several factors that have moved into unfamiliar territory.

The first is oil, which has moved toward $100 a barrel, up from about $60 at the start of the year. On an inflation-adjusted basis, it is close to the peak reached in the late 1970s, although oil prices generally do not influence the U.S. economy as severely as they did then.

Fortunately, says Siegel, gasoline prices have not matched the crude oil gain. Prices at the pump are still below the post-Katrina highs of two years ago. "I am more worried about gasoline spiking up to $4 a gallon and beyond than I am about the subprime crisis." Consumers may continue to spend even if the fall in home prices makes them feel poorer, he adds, but he doubts they would do so if hit by a big spike in fuel costs as well.

While many factors affect oil prices, the falling dollar is a key one, since it makes imported oil more expensive. Early in November the dollar hit a record low against the Euro -- another hard-to-assess factor. Asked if the dollar could fall further, Herring says, "It could -- or it could rise. All we know scientifically about the exchange rate is that, like the stock market, it is very hard to predict."

Exchange rates are set by supply and demand on the enormous international currency markets, and observers are never sure which forces dominate traders' thinking. Many experts agree that traders are driving the dollar down as a kind of punishment for the U.S. budget and trading deficits. Those deficits mean the U.S. is shipping hundreds of billions of dollars overseas. In effect, that creates a huge supply that tends to drive the price of dollars down just as it would with any other commodity.

The Fed's recent interest rate cuts have contributed to the dollar's fall, since foreign investors find dollar-denominated investments like U.S. Treasury bonds less attractive when yields are lower. Lower demand drives prices down.

China is the biggest buyer of dollars, packing some $1.4 trillion into its reserves in an effort to reduce the worldwide supply and thus shore up the price so Americans can continue to be big buyers of Chinese goods. On November 7, a Chinese official frightened currency traders by suggesting China might diversify its currency holdings. If China were to sell significant dollar holdings, the jump in supply would drive the dollar down further.

Analysts quickly noted that the official was not involved in setting China's currency policy, and some wondered whether he was being used to test the market's reaction to the idea. Several experts agree, however, that China simply cannot afford to dump many of its dollars, as a gush of supply would drive the dollar down further and reduce the value of China's remaining dollar holdings. "If they did that, it would reverse the effects of their foreign exchange intervention, which keeps the dollar high and the [Chinese] exports humming," says Marston. Adds Herring: "Those who run the reserves realize [that dumping dollars] would be terribly punishing" to China itself.

According to Nini, concern about the dollar influences Fed actions. Though it can cut interest rates to stimulate a slowing economy, the Fed is reluctant to do so for fear that would drive the dollar down further, causing the cost of foreign goods to rise, igniting inflation. Hence the Fed's fence sitting.

For the moment, Nini says, the financial markets don't seem to view inflation as a serious threat. Inflation worries are signaled by a widening margin between the yields on ordinary 10-year Treasury bonds and 10-year inflation-indexed Treasuries. That margin has not been widening, he notes.

The Subprime Puzzle

Among the biggest unknowns for the U.S. economy and financial markets is the magnitude of the subprime lending fallout. This crisis began last winter when millions of homeowners found their mortgage payments rising as interest rates reset to higher levels. More and more of these borrowers, generally people with weak credit, fell behind on loan payments and entered the foreclosure process. That drove down prices of securities based on subprime loans.

Six months ago, most experts thought the damage would be limited to some hedge funds and other big investors that had gambled on these risky securities in a hunt for high yields. But in the late summer and fall, major Wall Street firms began reporting multi-billion dollar losses. Then, they conceded losses were even bigger than first reported. The heads of Merrill Lynch and Citigroup were ousted.

"To think that the heads of two of the largest firms on Wall Street would be fired would have been inconceivable a few months ago," Marston says. Although Marston had thought in the spring that many experts were underestimating the damage taking place in the housing and mortgage markets, even he had not expected it to evolve into a broader credit crisis, he notes.

The big question now is whether the full extent of the problem is known -- an uncertainty contributing to the jitteriness of the financial markets. "This is exactly why people are taking so much more of a pessimistic view," Herring says. "What we know so far is that the [mortgaged-based securities] in 2006 and 2007 are already performing much worse than their counterparts at any time in recent history."

It could be another year, or even two, before the full extent of the damage is clear, Herring adds, since many of these securities are based on adjustable-rate mortgages that have yet to reset. Many homeowners who cannot afford new, higher payments won't be able to sell their homes to pay off their loans because home prices have fallen and sales have slowed. "All of this means the situation will get uglier before it gets better. Even now, it's hard to know exactly where the other shoe is going to drop," Herring suggests, adding that it is impossible to predict what will happen because many of the subprime mortgage products, and the securities based on them, are too new to have a track record.

Even mortgaged-backed securities with good ratings have unexpectedly fallen in value by 20%, 30% and even 40%, so that many investors who thought they were playing it safe "are ending up with much riskier portfolios than they expected," Herring points out.

According to Wharton finance professor Marshall E. Blume, it was not just the subprime-based securities that were overpriced and destined for a fall. High-yield corporate bonds, for example, carried yields that were not significantly higher than those of investment-grade corporate bonds, indicating that investors were underestimating risks.

The collapse in the subprime markets "was a wakeup call that things were priced too high across the whole spectrum," Blume says. He believes more Wall Street firms will shake the market with surprising losses. Lenders have already become stingier, making it harder for individuals and businesses to borrow, Blume adds. That weakens the economy. "I think we're basically coming from a bubble economy to a more realistic economy. And whenever you do that, things are painful."

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