Economists' forecasts get gloomier, predict more rate cuts

Defeat of the financial rescue package led economists Monday to downgrade already gloomy forecasts for the economy, arguing the news from Capitol Hill would further depress business and consumer confidence.

Some, such as those at economic consulting firm Global Insight, predicted the Federal Reserve would soon cut its target for short-term interest rates to try to give the economy a boost. But it's unclear how much that would do given the problem isn't lending rates, but a lack of ability or desire on the part of banks to lend at any price.

"This is an extremely worrisome situation," says Lyle Gramley, a former Fed governor now at the Stanford Financial Group. "We are going to go through a significant recession even if the bill passes. Without it, we could have the worst recession of the post-war period."

First Trust Advisors economists Brian Wesbury and Robert Stein, who had firmly been in the "no recession" camp before Monday, said their opinion had changed.

"Never in history has a drop in consumer confidence caused a recession," they said in a note to clients. "But that does not mean there won't be a first time. It could happen in the next few months and we would expect to see some very negative (economic) data."

The economists noted that the House rejection of the plan came after top officials, including President Bush, Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson, warned of dire consequences if something was not done. Now that Congress has rejected the bill, at least for now, people are likely to hunker down even if they are not feeling a direct effect of the credit crunch.

But some economists say concerns may be a bit overblown.

"Credit conditions may well be difficult for a period, but I don't think there's anything to suggest this is going to be Armageddon," says Jeffrey Miron, a senior lecturer in economics at Harvard University who opposes the bailout. He argues companies should be allowed to fail. "Somebody has to pay for the mistakes."

Consumers, whose spending accounts for more than two-thirds of all U.S. economic activity, were pulling back even before the financial meltdown hit a fever pitch this month. Consumer spending was flat in August, the Commerce Department said Monday.

"The economy looks terrible," says Donald Straszheim, vice chairman of Roth Capital Partners. He predicts more banks will soon fail and businesses will have to close because they won't be able to get cash for day-to-day operations. "What business person would hire right now given the uncertain and negative environment? Nobody."

Straszheim was one of the economists who predicted the Fed would soon cut its target for short-term interest rates.

"It would be another signal that the Fed sees the danger here and is pushing wherever they can, but I don't believe it would have much effect," he says, noting the Fed's interest rate is already low.

The Fed's interest rate target, which influences borrowing costs economy-wide, is at 2%, the lowest since December 2004. After the House vote, investors in a futures market in which participants bet on future Fed moves upped the odds of a rate cut at the next meeting on Oct. 28-29, according to Action Economics.

James Paulsen, chief investment strategist at Wells Capital Management, however, says a rate cut could backfire on the Fed by further fueling panic. "You add to the mania," he says.

The Fed has been taking a number of actions to try to pump money into banking systems in the USA and abroad. Monday morning, the Fed said it was increasing its so-called swap lines with foreign central banks to $620 billion from $290 billion in an effort to keep dollars flowing worldwide. It also said it was increasing the amount of loans it would make to domestic banks.