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Economy may be hooked on low interest rates

Reuters News Service

NEW YORK The Federal Reserve has been widely credited with rescuing the U.S. economy from recession with a prescription of super-cheap money, but some analysts are worried the patient is becoming addicted to the cure.

Although consumer inflation remains very low, asset prices are surging again, and investors are taking ever greater risks to make a buck, potentially creating other imbalances.

U.S. blue-chip stocks last week touched a 32-month high, helped by signals from Fed Chairman Alan Greenspan that he is in no rush to lift interest rates from 1958 levels. The housing market shows little sign of cooling, and the premium investors demand to lend to companies is the lowest on record.

The Fed has ended up "with an economy addicted to rock-bottom nominal interest rates," said Stephen Roach, chief economist at Morgan Stanley.

The Fed decided not to tackle the 1990s stock bubble with higher interest rates, instead preferring to mop up the aftereffects with a massive jolt of 13 rate cuts, a strategy Greenspan declared "successful" last month in a burst of self-congratulation that critics warned was premature.

"Ironically, post-bubble America finds itself even more dependent on asset markets than was the case during the prebubble buildup," Roach wrote in a research note.

That is partly because companies have been so slow to add jobs, leaving consumers more dependent on other sources of income, including home refinancing, which poured $130 billion into homeowners' pockets last year.

Because interest rates are so low, investors have been searching for better returns elsewhere. They are pouring money into mutual funds and even the lowliest-rated junk bonds with little regard to risk and have sent the Nasdaq up 50 percent since 2003. The fear is that when markets finally correct, as they always do, the plunge will be just as savage as in 2001 and 2002.

That puts the Fed in a tight corner because any hint of a rate hike tends to send markets into a tizzy. But with rates at just 1.0 percent, some analysts argue that they need to get back to more normal levels to meet any unexpected shocks not to mention the next cyclical downturn.

Roach says it is time for the central bank to "reload the cannon."

Others contend that bringing some sanity back to markets may not be a bad idea.

"It might be the case that the Fed at some point feels compelled to tighten, to constrain the emergence of another asset bubble," said HSBC chief economist Ian Morris.

"If stock values keep surging and if real estate markets keep moving higher, there must come a point where some will say, 'Maybe we should be doing what the Bank of England is doing and not just take into account consumer prices but asset prices as well.' "

The Bank of England is not alone in its concerns. The Reserve Bank of Australia also alluded to overheated housing markets as a reason for its recent rate rise.

The European Central Bank's chief economist, Otmar Issing, asked in an article in the Wall Street Journal on Wednesday how much responsibility central banks should take in dealing with asset price inflation.

"Should it not be the role of central banks to communicate concerns in an appropriate form and thereby to try to contribute to a more sober assessment of asset price developments?" Issing asked.

The Fed, however, seems blithely unconcerned.

Apart from Greenspan's isolated warning of the stock market's "irrational exuberance" in 1996, the Fed has painstakingly steered clear of judging whether a bubble is in the making. Moreover, Greenspan has said the central bank should not direct policy to deal with one.

Greenspan reiterated that approach in testimony to Congress on Feb. 11, when he said it is difficult to tell when markets are overvalued.

Even if investors are becoming irrational again, maybe it's a problem for tomorrow.

"There probably are some bubbles in the making, but you can't worry about those now," said Bank One chief economist Diane Swonk. "They have a dual mandate employment and inflation and they've got no inflation and not enough employment."


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