Swiss Re Economist Comments on Fed Rate Cut

Swiss Re’s Chief US economist, Kurt Karl, issued a comment following the decision by the Federal Reserve to lower the target fed funds rate 50 basis points to 4.75 percent. He described the move as a “strong action to alleviate the market turmoil.” Karl indicated that the market had been “hoping for 50 bp,” and said the Fed’s action in accord with that figure is a “clear signal” that it is “willing to provide liquidity and reduce market turbulence.”

Karl observed, however, that at this time “the risk of a recession over the next 12 months is still 35 percent due to the weak growth, market turmoil and elevated oil prices. Slow growth should lower inflation further, so the Fed should have few concerns about inflation and is expected to continue cutting rates.”

He warned that the “September US employment report precludes any optimistic scenario for the US economy — growth will be weak at best, or negative with a recession over the next 12 months.” He remained optimistic that “any recession is expected to be short and shallow.”

According to Karl the equity markets are “not highly overvalued,” and “would rebound quickly.” However, he sees credit markets as continuing to “experience heightened volatility.”

In the near future Karl forecasts that the Fed will “lower the federal funds rate to 4.5 percent by year-end. This will support real GDP growth of 2 percent to 2.5 percent next year, but inflation will decline modestly and the yield on the 10-year Treasury note will be 4.0 percent to 4.5 percent by end-2007, rising to 4.75 percent by end-2008 as the economy strengthens.”

If there’s a real “recession scenario,” he sees the Fed cutting rates ultimately to 3.0 percent or lower, while “real GDP growth is about 1 percent next year, inflation approaches 1 percent and the yield on the T-note is 4.0 percent by end-2007 and 4.5 percent by end-2008, if not lower in both years.”

Karl characterized global growth as remaining firm, “despite the many problems in the US. Euroland growth is fairly strong and the UK economy continues to perform well. However, the weakness in the US is assumed to alleviate growth and inflation pressures in Europe so that both the European Central Bank (ECB) and the Bank of England cut rates once, by 25 basis points each, by year-end.

“Japan’s growth may be slowing and its inflation low, but the Bank of Japan is still expected to raise rates one more time this year, to 0.75 percent, and next year to 1.25 percent by end-2008.

“China continues to boom, so is expected to allow the renminbi to appreciate by about 6 percent per year, which will help to slow growth and lower inflation. Inflation — and a possible hard-landing — is a rising concern in China.”

In conclusion Karl indicated that “the huge US current account deficit implies the U.S. dollar will continue to weaken a bit more against the Euro (to $1.40 by end-2007 and 2008) and quite a bit more against the yen (to 107 yen per dollar by end-2008).”

Source: Swiss Re – www.swissre.com.