Recession: What the cut won't do

NEW YORK (CNNMoney.com) -- Problems in housing, the financial markets and the first job decline in four years all played a role in the Federal Reserve making an aggressive rate cut Tuesday. But it has also raised talk about a recession - and whether the Fed is able to prevent one.

The Fed, citing the growing risk to continued economic growth, cut the benchmark fed funds rate by half a percent Tuesday, a bigger cut than many economists had forecast. It was the biggest cut since a half-point cut in November 2002, and the first rate cut of any kind since June 2003.

It's not clear how much Federal Reserve Chairman Ben Bernanke will be able to do if the U.S. economy does start to slide toward recession.

While most economists still don't believe the nation will fall into a recession, there is general agreement that the economy now faces a greater risk than there was only a month or two ago.

But many economists also say that the Fed can do little at this point to address many of the factors threatening continued economic growth. Some economists even argue that rate cuts could make matters worse.

The mortgage market would seem to be where the Fed could have the most effect. Most directly, a rate cut will reduce the rates for adjustable rate mortgages, one type of loan that has caused the problems for lenders and subprime borrowers, those with less-than-perfect credit.

An estimated 2 million homeowners face sharply higher mortgage payments when their current loans reset over the next year. So a Fed rate cut could possibly stave off a wave of foreclosures.

That's key since more foreclosures could have the potential to hurt consumer spending as a whole, said David Wyss, chief economist for Standard & Poor's.

"About 1 or 2 percent of the population is going to be seriously affected by these resets. That's not trivial," said Wyss. "One thing a Fed rate cut will do is reduce that reset shock fairly quickly."

But others say even a series of rate cuts won't solve the problem for those who have been paying low teaser rates on their mortgages with the expectations that they would be able to refinance before rates reset. The fact that investors no longer are willing to buy securities backed by such non-traditional mortgages could make it impossible for hundreds of thousands of those homeowners to refinance.

"A rate cut even down to zero percent doesn't make those attractive investments," said Edward Leamer, director of the UCLA Anderson Forecast, which now puts the chance of recession at about 30 to 35 percent. "The Fed is in the situation where they should not be thinking about saving housing. They should be thinking about isolating the problem strictly to the housing sector."

The mortgage problems have clearly led to a broader credit crunch in financial markets, which has already put a crimp on the financing of some proposed mergers.

The Fed's statement Tuesday mentioned the risk to the economy from that market turmoil as a motivation for the cut.

"Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time," the statementread.

While rate cuts may help get those markets functioning more fluidly once again, there is debate among economists about how great a risk the credit crunch poses to the overall economy.

"It's pretty hard to draw strong lines between the credit crunch on Wall Street and the economy, except in real estate," said David Kelly, economic adviser for Putnam Investments. "If there are some deals delayed, it's not a problem for real economic activity. In fact, usually mergers and acquisitions cost jobs. They don't create jobs, except with Wall Street firms. Outside New York, there shouldn't be much impact."

But Gus Faucher, director of macroeconomics for Moody's Economy.com, said that getting the credit markets working again is important for business confidence, which is a key driver in decisions by companies whether to hire new workers and invest in plants and equipment.

"Businesses are still sitting on a ton of cash. The question is if they are going to go out and use that," he said. And he believes this is an area where a Fed rate cut can have the most positive effect.

"They need to know if the Fed is on the job and ready to respond," he said.

But Putnam's Kelly said if markets start to assume that Tuesday's cut was the first of a series of many, it could put some needed spending by businesses and consumers on hold, as they wait to see how low the rates will fall, and how much the economy is going to slow down.

"I don't think they signaled that there will be more cuts; I don't think they know what they'll do at the next meeting," said Kelly. He added that he believes the Fed did its best to signal that future cuts are not certain.

"But there will be economists out there predicting this is the first of a series of cuts," he said. "If people believe that, it gives them reasons to have doubts about the economy and a reason to wait to make investment decisions. If you're trying to pick up a house at a bargain, will you do it now or wait six months? You'll wait six months."

Another risk to the economy would be a drop in foreign investment here, according to some economists. And a Fed rate cut might cause more problems than it fixes because lower rates would make some U.S. investments, such as government-issued Treasurys, less attractive to foreigners.

Leamer and Wyss said a steeper drop in foreign investment would be a big problem for the economy because that flow of funds has been key to keeping long-term rates low.

"Last year we had $1 trillion come in net foreign investment, most of it into the bond market, and most into private bonds, not Treasurys," said Wyss. "If that money stops coming in, that's going to be a big increase in borrowing costs."

A sharp drop in foreign investment would also feed into the slide in the value of the dollar. While that would make U.S. exports more competitive, it also would likely raise the price of imported goods and hurt the spending power of U.S. consumers, who have come to count on low-price imports for everything from food to clothes to cars.

Wyss and Leamer say they're not predicting a sharp drop in foreign investment, but that it is a concern. And economists say there's relatively little the Fed can do to keep investors from outside the United States from pulling back on U.S. assets if it is cutting rates.

"The Fed has to make its primary concern what is happening to the domestic economy," said Wyss. "You can't focus on the dollar."

The Fed also has little ability to affect another risk to the economy: high oil prices. Crude oil prices hit $80 a barrel for the first time Sept. 12, and hit record-high closes both Monday and Tuesday.

While the economy has kept growing with oil in the $60s and $70s, economists say rising prices are a bigger risk now given how vulnerable the economy is. High oil and gas prices would be just one more thing for an already nervous consumer to worry about.

"I think if this lasts for two to three months, it's going to be a problem," said Faucher about oil prices. "If this was happening when the economy was going great guns, I wouldn't be as concerned. But more than just the costs, this can affect consumer psychology. If it shows up at the pump, then we've got some problems."