Henry Kaufman is staying true to his sobriquet as Dr Doom with a new prediction: The Federal Reserve will be forced to slash interest rates if stock markets fall steeply.
Kaufman, who became known as "Dr Doom" for correctly forecasting higher inflation and interest rates when he was chief economist with Salomon Brothers in the 1970s and 1980s, like others expects the Fed to keep interest rates steady for the foreseeable future.
But he sees a scenario that could change that. "If we were to have a 15 percent decline in share prices from here on, that would make the Fed rethink its strategy," said Kaufman, founder and chairman of financial consulting firm Henry Kaufman & Company, Inc, in an interview with Reuters on July 31.
An erosion of stock market wealth, combined with the weakening housing market, could crimp US consumer spending and than in the last couple of years," Kaufman said.
The sell-off in subprime mortgage assets is one of the main reasons why credit conditions in financial markets are tightening and why global investors are becoming more risk averse.
"For a while, financial market participants will be more circumspect in the allocation of credit," Kaufman said. Trouble in the subprime debt market has raised some unanswered questions.
"We don't know as much as we should about ... how much of the subprime obligations are still in transitory hands" of dealers and investment banks, he said. The relationships these market participants have with hedge funds is also unclear, as is the extent to which subprime holders have tried to limit their risks with derivatives.
"All of this is up in the air," he said.
Investors are waiting to better assess this fallout from the subprime market, which may become clearer when banks and investment banks issue their next quarterly reports in September and October, Kaufman said. At that time, "there will be far more disclosures as to losses they have had to take," he said.
Asked what role the Federal Reserve played in extending credit and the weakening of the housing market, Kaufman said: "The Fed has contributed in the aggregate, in the broad sense, to the housing bubble."
There has been a substantial increase in debt of both households and businesses that is "to a large measure the function of monetary policy," he said.
The policy-setting Federal Open Market Committee had cut the overnight fed funds target interest rate to a four-decade low of 1 percent in June 2003, and kept the rate there for a year. The Fed then raised the funds rate over two years to 5.25 percent, where it has been held since June 2006.
Asked what Fed Chairman Ben Bernanke can do to alleviate problems in the housing market, Kaufman suggested the impact of the housing bubble will be difficult to control.
"Once the train has left the station, slowing the train down is not very easy," he said. Over the last 20 years the financial system has believed it will be bailed out by the central bank, while both corporate borrowers and households now have a different attitude toward borrowing than, say, in the 1970s in the United States, he said.
"Today, it is your capacity to borrow that is your prime liquidity concept, a big difference from the past," he said. In the 1970s "the effort was to pay off a mortgage," he said. "The current generation has no desire to do so." Asked what was the danger of an event similar to the savings and loans crisis of the 1980s and 1990s, in which the banking sector incurred hefty losses, Kaufman cited unknowns under the present situation.
"We had far better information regarding the S&L crisis than we do under the present system," because of the use of derivatives and debt obligations, he said. "The linkages in the present system are far more intricate."
Kaufman also warned about rising global inflation pressures, saying that pressures in the world economy including demand for commodities from fast growing economies "will provide some upward bias in the inflation rate."