Fed urged to cut rates or face recession

The Federal Reserve heard a plea for a full percentage point cut in US interest rates in order to forestall a recession, as central bankers debated the fall-out from the housing market slowdown.

The US central bank's annual symposium in the quiet mountain town of Jackson Hole, Wyoming, has this year been dominated by the questions of if and how monetary policy should respond to changes in house prices. The event has been scrutinised as never before by investors and economists for clues as to how the Fed may act at its next rate-setting meeting on18 September.

The Harvard University economist Marty Feldstein, who heads an independent group that charts US business cycles, arrived at Jackson Hole to deliver a warning that sharp declines in house prices in many areas of the country could trigger a much broader recession, if the Fed did not act.

Lower rates may trigger a period of high inflation, which would have to be dealt with over time, but this was the "lesser of two evils", said Mr Feldstein, whose National Bureau of Economic Research is the recognised arbiter of whether the US is in recession. "The economy could suffer a very serious downturn," he said. "A sharp reduction in the interest rate, in addition to a vigorous lender-of-last-resort policy, would attenuate that very bad outcome."

Mr Feldstein made a case for lowering the overnight lending rate between banks to 4.25 per cent from 5.25 per cent to cushion the economy from the fall-out of defaults on so-called "sub-prime" mortgages, home loans handed to people with poor credit histories.

"Marty is a guy of good judgement," the former Fed governor Lyle Gramley told Bloomberg News after hearing the speech. "Everybody in the room recognises that. Everybody, including the people at the Fed, will think carefully about what he said."

The Federal Reserve chairman, Ben Bernanke, opened the Jackson Hole conference onFriday with a promise to act as necessary to prop up economic growth and to restore the health of the financial system, where sub-prime mortgage defaults have caused a cascade of other problems.

The Fed and other central banks across the world have been forced to pump billions of dollars into the financial system toprevent a seizing-up of credit from lenders who are increasingly fearful of hidden mortgage losses among financial institutions. A total shutdown of credit appears to have been averted for the time being, but banksare offering loans on much tighter terms, and hedge funds are having to cut the amountof leverage they use to inflate their returns.

"What we need to do ascentral banks, and we are clearly doing that, is to help them in the deleveraging process," said Axel Weber, president of the German Bundesbank and a member of the European Central Bank's governing council, who spoke in Wyoming. "There is no underlying problem of solvency, it's one of liquidity. So swift action is needed."

The Federal Reserve governor, Frederic Mishkin, struck an optimistic note, saying that US banks can cope with "stressful" conditions. "The overall financial system appears to be in good health, and the US banking system is well positioned to withstand stressful market conditions," he wrote in a paper presented at the conference.

Addressing one of the underlying issues of the conference, Mr Mishkin said the Fed should not use interest rate policy to prevent or prick bubbles in the housing market, but simply use its regulatory powers to ensure responsible lending and use rate changes to manage the wider economic consequences.