By Jim Christie
BERKELEY, California (Reuters) - Trends in the U.S. economy are "deeply worrisome" at a time when damage from the credit crunch has outpaced the Federal Reserve's huge interest rate cuts, a top Fed policy-maker said on Thursday.
Janet Yellen, president of the San Francisco Fed, said the U.S. central bank's benchmark lending rate, which has already been cut in response to an economy plunging toward recession, could "potentially ... go a little lower" than the current 1.0 percent.
Yellen was the first Fed official to speak after Thursday's news that the U.S. economy had shrunk by 0.3 percent in the third quarter, and she suggested the worst was yet to come.
"For the fourth quarter, it appears likely that the economy is contracting significantly," she said at a University of California symposium in Berkeley, California.
"The mortgage meltdown is far from over (and) the economy and financial markets are still reeling from it."
Most private-sector borrowing rates are higher now than at the start of the financial crisis in August 2007, despite "some of the most momentous steps in decades" from the Fed, she noted.
"I don't mean to imply that the rate cuts did no good; borrowing rates in my view would be substantially higher absent the reduction in our base lending rate," said Yellen, who will vote on the Federal Open Market Committee in 2008 in 2009.
The FOMC on Wednesday voted to cut the benchmark federal funds rate by a half percentage point to 1.00 percent, the lowest since June 2004. The Fed has cut rates by 4.25 percentage points since September 2007.
Financial markets point to another cut at the December FOMC meeting, to 0.75 percent or even lower.
Yellen said the Fed would not need to push rates to zero given the dramatic pace at which it is expanding its balance sheet.
The central bank appears to have kicked off a process known as "quantitative easing," flooding the market with liquidity and allowing the federal funds rate to trade in the interbank market below the announced target rate.
The Fed's asset base could hit close to $3 trillion by year end against about $800 billion a year ago, Yellen said.
VICIOUS CYCLE IN FULL SWING
Yellen has warned for months about a vicious cycle between reduced credit availability, weakened financial institutions, and the broader economy, and said the "adverse feedback loop" is now in full swing.
"A greatly reduced flow of credit in the economy ... is the major factor responsible for the economic downturn that now is under way," she said.
For consumers, though, the credit problem is just one of "several negative factors" now at work, including a 9-month streak of lower monthly payroll employment, flat personal incomes and lower stock markets and housing values.
The Fed's steps to support credit markets are "extremely constructive," and will thaw credit flows over time, she said, citing "very tentative signs of an easing of stress in money markets."
But with a long way to go before the credit crunch is totally alleviated, other types of policies, including programs that give direct assistance to homeowners to stem the flow of foreclosures, are worth pursuing, Yellen said.
"The bottom is not yet in sight" for falling house prices or housing starts, she said, adding that although prices need to correct to bring buyers back into the market, "we are in danger of over-correction."
"By mitigating foreclosure sales at fire-sale prices, these programs may also support housing prices more generally and serve to limit the credit losses that have done so much damage to the financial system," she said.
Yellen said it also "certainly makes sense" for Congress to act on broader fiscal policy measures at this point to shore up the economy.
(Writing by Ros Krasny)
