July 2010

With the sting of 2008’s recession still smarting, markets globally remain sensitive that Europe’s financial troubles could devolve into another credit crunch. Spooked by concern that eurozone countries might struggle to fulfill their debt obligations, and still beset by problem commercial real estate loans, already-hesitant banks and other lenders continue to balk at creating credit.

In the United States, federal flow-of-funds data for the first quarter 2010 showed the U.S. economy remained starved for credit creation from the financial sector, and net lending shrank even though official U.S. interest rate benchmarks remain near 0%. This is particularly noteworthy because government data show that from 1952 through 2008, net lending by the entire U.S. financial system had never contracted.

“Something is wrong with the transmission mechanism between the Fed and the economy. The private financial system is not transforming the inexpensive credit being offered it by the Fed into credit for the private nonfinancial sector of the U.S. economy,” said Paul Kasriel, Northern Trust’s chief economist. “I consider this financial sector net credit contraction the major headwind for the economy, preventing a more normal robust cyclical recovery.”

Although U.S. economic reports do not show a significant weakening directly tied to the crisis in Europe, the EU austerity plans clearly have driven the rally in the U.S. bond market as investors sought the safe haven status of U.S. government-backed debt instruments.

Inflation also poses no threat, as gun-shy consumers fretting about a jobless recovery and still-weak housing prices opt to bank rather than spend their cash. In fact, U.S. consumer-level prices for the 12 months ended April only rose 0.9% when trimmed of the most-volatile components. “Inflation in the U.S. today is not a clear and present danger,” Kasriel added, noting that extremely low or even declining prices — deflation — might prove more nettlesome than the specter of inflation.

Ultimately, the impact of these overseas spending and deficit cutting plans could weigh on U.S. growth, giving the Fed no reason to tighten credit policy anytime soon.

“Given the fiscal austerity packages being implemented in Germany, the U.K. and Japan, and the lack of credit creation in the U.S. by monetary institutions,” Kasriel said, “the Federal Open Market Committee may keep the fed funds rate at a lower level for an extended period in order to evaluate the effects of the cross-currents affecting the U.S. economic and financial environment.”