(Agencies)
Updated: 2007-12-24 12:15

The administration also is working with Congress to increase the US$417,000 cap on the size of loans that the big mortgage companies Fannie Mae and Freddie Mac can handle. This step could help in high-cost housing areas such as California.

In addition, the administration is supporting legislation that would boost aid to lower-income homeowners by increasing the scope of mortgage insurance programs handled by the Federal Housing Administration.

These efforts may help at the margins. They do not, however, address one of the biggest threats to the economy: a spreading credit crisis triggered by the soaring defaults on subprime mortgages.

Some of the biggest names in finance have suffered multibillion-dollar losses as a result, and critical segments of the credit markets have frozen up. Banks and investors fear making further loans or buying securities backed by debt because they do not know how many more loans might go into default.

Ben Bernanke, facing his first major test as Fed chairman, is getting mixed reviews. The Fed was embarrassed when the credit crisis hit in August. That happened only two days after the central bank had decided to keep interest rates unchanged and declared that inflation was a bigger risk than weak economic growth.

The Fed has cut interest rates by a full percentage point since that time. But only the September cut - a bigger-than-expected one-half of a percentage point - elicited cheers on Wall Street. The two quarter-point moves brought about market declines as investors worried the Fed did not recognize the severity of the problem.

The trouble is that the credit crisis is occurring at the same time that a run-up in energy prices is increasing inflationary pressures.

And that is the dilemma.

If the Fed cuts interest rates to keep the economy out of a recession, it could sow the seeds for higher inflation and perhaps give the country the worst of both worlds, bringing back that 1970s bugaboo, "stagflation," in which growth is stagnant and inflation is getting worse.

In a novel approach, the Fed is auctioning off money to the banks in an attempt to get them to open up their loan spigots. The first two auctions, for a total of US$40 billion last week, went well. But the amount of the cash provided to the banks paled in comparison with the $500 billion from the European Central Bank.

Many economists believe the Fed will have to cut its federal funds rate, the interest that banks charge each other, at least three more times and strengthen the wording of its statements. In that way, the markets would know the Fed will do whatever is needed to fight economic weakness in spite of its lingering worries about inflation.

"The difference between a soft economy and a recession is confidence. If the Fed appears reticent to do what is needed, like they did at their last meeting, that does not help confidence," says Mark Zandi, chief economist at Moody's Economy.com.

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