Cut or Not to Cut?

the entire construction sector in the US is 5 percent of GDP. The bit that is hurting badly, residential construction is somewhere between 3 and 4% of GDP. Exports are 12% of GDP and growing in volume terms at an annual rate of over 11%. Import competing industries are also doing well. The combination of a sharp nominal and real depreciation of the US dollar and continued rapid growth outside the US accounts for the strength of the externally exposed sectors of the US economy. It goes a long way towards offsetting the weakness of parts of the nontraded sectors, including housing. While increased credit risk spreads represent a tightening of monetary conditions, the weaker dollar represents a loosening of monetary conditions.

A 25 bps cut in the Federal Funds rate on September 6 is unnecessary, likely, but my no means a foregone conclusion. By the time Congress is done augmenting the Bush mini bail-out of financially stressed mortgage holders, there may be a fiscal stimulus worth about 0.5% of GDP. With elections looming, this fiscal stimulus could be enacted rather swiftly. The anticipation of relief on both the fiscal and monetary side is likely to be enough to normalise credit conditions (albeit at spreads closer to long-run historical levels rather than at the anomalously low levels of 2003-mid 2007) and to provide a boost to asset markets. The US housing market is in structural trouble, with excess capacity in most categories that will take years to work off. But that is a small enough part of the US economy not to be a serious drag on overall activity in the years to come.