A Cautious Step on Credit

• Fed officials signaled a halt to active credit easing efforts but the desire to maintain the cap on expected
interest rates highlights that there are still keyuncertainties in the outlook for growth, financial stability and inflation.

•Moderate growth in household spending and fading weakness in labor markets suggest recovery is approaching
a critical stage. While fiscal thrust is losing itsforce, the earlier drags from large negative wealth effects on spending
also appear to be running their course.

•We expect a small rise in employment for January. However, the latest softening in risk assets warns that policymakers
on all sides need to be mindful of their role insustaining the improvement in financial conditions. The continuing retreat in
bank lending/loan demand illustrates a key headwind.

A Cautious Step

This week’s policy statement from the Federal Reserve encapsulated some key
tensions in the outlook. Policymakers are optimistic enough about recovery’s
prospects to proceed with a planned halt to the active phase of credit easing.
But the desire to maintain the cap on expected interest rates indicates that
their confidence has not reached a level that would point to a timetable for
unwinding extreme accommodation.

Fed officials have signaled an end to
credit easing but are still uncertain about
a timetable for higher rates.

One month into the new year, both market developments and incoming data
have behaved in a wobbly manner. Credit and equity markets have languished
following massive rallies. In addition to nagging doubts about the economy,
investors are focusing on wide areas of policy uncertainty that could feed back
negatively on the recovery. One of the many frustrating aspects of the
recession and its policy controversies is that so much of the public still
struggles to accept the link between a healthy, smoothly functioning financial
system and the most basic measures of economic success like job growth.

Markets and data reflect lingering
uncertainty about recovery and policy’s role.

The past week or so has featured the downside effects of the earlier anticipated
end to first-time homebuyer credits. While those credits are back in place until
June, the pause has introduced a lot of noise in the data. The 16% plunge in
total new and existing home sales reported this week for December was
telegraphed by lower pending sales as well as downbeat readings on buyer
traffic and mortgage applications. There is more of this payback in store and it
underscores the dominant role that government support — both direct and
indirect — has played in the housing recovery to date.

Falling home sales illustrate the
importance of government aid in the
housing recovery.

Nonetheless, as discussed last week, we are satisfied that housing markets
broadly are in transition with much needed adjustments behind them. After
being an overwhelming drag on the economy and financial sector, housing is
making modest contributions that will show up in construction and once again
in sales (see Figure 1), especially as credit conditions gradually heal and
affordability overtakes worries about falling prices. We continue to expect
renewed price declines in houses, but the risks here no longer present the
same deterrent they did when prices were unsustainably high.

But lower, more stable prices and slowly
improving credit conditions should bolster
housing markets this year.

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