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Buying Time for Rate Cuts to Work

WASHINGTON, Jan 6 (Reuters) - Central bankers desperate to avoid a U.S. recession are searching for the right mix of talk and action to restore confidence among consumers, companies and capital markets, and buy time for interest rate cuts to work.

Weakening housing, manufacturing and U.S. employment data leave little doubt that U.S. and European economic growth are slowing, and no amount of rate cutting in January would change that. If policymakers can get consumers spending, businesses working and financial markets functioning for six more months, they may be able to get past the worst of the U.S. housing market meltdown and salvage a global economic expansion.

This week, investors will get a good look at central bankers' views of 2008, and how they hope to shield the world economy from the housing malaise and credit contraction without stoking already hot inflation.

Group of 10 monetary leaders wrap up meetings on the global economy in Switzerland on Monday; the Bank of England and the European Central Bank meet on Thursday to set interest rates; and seven U.S. Federal Reserve officials, including Chairman Ben Bernanke, have speeches scheduled during the week.

Economists expect the ECB, and possibly the BOE, to hold interest rates steady, while Fed members may signal a willingness to cut more after reductions in September, October and December. Minutes from the Fed's Dec. 11 meeting, released last week, said the U.S. central bank was "exceptionally alert" to economic and financial developments.

Their task got tougher last Friday when a government report showed the U.S. labor market created far fewer jobs than expected -- a mere 18,000, the weakest since job losses in August 2003. The unemployment rate jumped to 5 percent.

While policymakers are loathe to publicly utter the "R" word, the fate of the ailing U.S. economy and its global knock-on effects will no doubt dominate discussions. Eminent economists, including former Fed Chairman Alan Greenspan, conclude that the chances of a hard landing have increased.

"We see a broad-based slowdown that is a mile wide. It's unclear how deep it is," said Lakshman Achuthan, managing director of the Economic Cycle Research Institute, a private forecasting group based in New York.

On Friday, the group's closely watched weekly index of leading U.S. economic indicators hit its lowest level since November 2001, the tail end of the most recent U.S. recession. Achuthan said while the gauges were not signaling an imminent recession, nor were they pointing to an upturn any time soon.

Financial markets are also flashing warning signs. The spread between U.S. Treasury three-month bills and the Eurodollar is the widest since the 1987 stock market crash. Goldman Sachs calls this an elevated sign that the U.S. economy is in, or about to enter, recession.


Central bankers endured some harsh criticism and second-guessing last year for being slow to recognize how a web of complex securities linked to failing U.S. subprime mortgages could ensnare banks around the world and lead to a credit crunch. Many on Wall Street thought the Fed waited too long to lower interest rates when credit markets froze last summer.

As financial losses grew, the Fed, Bank of Canada and Bank of England all have eased but it will likely be mid year before the first of the Fed's cuts take hold in the U.S. economy.

The question is whether the medicine will arrive in time.

While economic growth remained surprisingly resilient in the third quarter and the beginning of the fourth, recent data suggest the slowdown has steepened. The U.S. manufacturing sector contracted in December while European factory growth cooled. Holiday season spending looks lackluster as steep food and energy costs took a bigger bite out of household budgets. The U.S. job market appears to be faltering. Companies are balking at big investments for fear of a deeper downturn.

Mickey Levy, chief economist at Bank of America, said the contraction in U.S. manufacturing data in particular was "really a kick in the teeth. Nobody knows whether it's a one-time gap down or the beginning of a negative trend."

Rate cuts alone cannot fix the U.S. housing market, where tightening credit conditions are shrinking the pool of potential buyers for a glut of unsold homes.

They cannot fill billion-dollar holes in banks' balance sheets left by failed bets on subprime mortgages.

And they cannot bring oil prices down from $100 a barrel.

"The Fed is limited in what it's capable of doing, and the market doesn't understand that," Levy said. "Part of the negative side of Greenspan's legacy was the market's perception that all the world's problems can be solved by Fed easing. That's just absolutely not the case."

The hope is that they can bolster consumer and corporate confidence long enough to get the U.S. economy through the next couple of quarters without slipping into recession.

That may be the best hope for Europe's economy, too. A U.S. recession would surely drag down European growth, and the ECB is particularly reluctant to cut rates when inflation at 3.1 percent is firmly above its 2 percent ceiling.

"They (ECB) will not tolerate inflation and they've got it," ECRI's Achuthan said.