Can the Fed’s balancing act save the US economy?

This feature is part of our FREE daily Money Morning email. If you'd like to sign up, please click here: sign up for Money Morning.

The world's biggest economy faces the prospect of a sharp slowdown, driven by a slump in the housing market.

So naturally, stock markets around the world are booming again. The Dow Jones Industrial Average is at its highest level ever, and markets in Asia and Europe are once again heading for multi-year highs.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

The hope is that the US has found the Goldilocks' spot again - that the economy will be neither too hot, nor too cold. And importantly, that the Federal Reserve will have to cut interest rates to prevent a house price crash.

But the markets may be getting ahead of themselves

US Federal Reserve chairman Ben Bernanke has warned markets that inflation is still too high in America. Its "above what we would consider price stability," he told Washington's Economics Club. "We have to watch it very carefully to make sure it does not rise or even remain where it is."

He's not the only one. Vice chairman Donald Kohn said that "he's more worried about persistent inflation than a slowdown in growth," according to Bloomberg. He warned traders: "Don't sell the Fed's concern about inflation short. Further upward movements in inflation would be very adverse to the economy and would, I think, require policy actions."

But Bernanke also pointed out that he believes the slump in the housing market will dent growth, wiping one percentage point off US growth in the second half of this year. Figures from the Institute for Supply Management (ISM) showed that growth in the services sector in August was its slowest since April 2003. The sector accounts for 80% of US economic activity, and the slide was caused mainly by the rapid slowdown in the housing market.

Ultimately, the Fed is treading a fine line. Bernanke is still keenly aware that his credentials as an inflation-fighter are far from sound. We're sure he must at times regret his speech, all those years ago, about fighting deflation by dropping money from helicopters - these things have a habit of coming back to haunt you just when you least need it.

We're absolutely positive that Bernanke's main instinct is to slash interest rates right now. And we're not surprised. The prospect of being in the hotseat during a crash in the biggest housing bubble in the countrys history cant be very pleasant. No wonder Alan Greenspan bailed out when he did.

But the Fed can't be seen to be just shrugging off inflation, which is after all, still extremely high in the US compared to the UK. The US is relying on foreigners to buy its debt - if they work out that the country's top central banker, the man in charge with maintaining the value of their investment, couldn't care less if the dollar halves in value as long as it keeps house prices afloat, then they'll start selling that debt.

That would drive up long-term interest rates, which unlike in the UK, are the main driver of mortgage interest rates rather than the rate set by the Fed. So that would put more pressure on the housing market anyway.

Bernanke's Fed is walking a very slender tightrope in the face of some very strong winds. Markets are putting a lot of faith in his ability not to lose his footing. We don't share that faith. For more on why, subscribers can read our recent cover story: Why Ben Bernanke's balancing act will fail

And If you're not a subscriber yet, you can get access to all the content on the MoneyWeek website and sign up for a three-week free trial of the magazine, just by clicking here: Sign up for a three-week free trial of MoneyWeek.

Turning to the wider markets

Enjoying this article? Why not sign up to receive Money Morning FREE every weekday? Just click here: FREE daily Money Morning email.

In London, the FTSE 100 closed 29 points higher, driven by rumours of M&A activity surrounding blue-chip steel group Corus and Barclays bank. Positive broker comment lifted Vodafone and sweetener-maker Tate and Lyle to the top of the leader board. However, falling commodities prices saw miners make the biggest losses of the day. For a full market report, see: London market close

On the Continent, the Paris CAC-40 closed 36 points higher, at 5,256, driven by financials. And in Frankfurt, the DAX-30 was 54 points higher, ending the day at 6,046.

On Wall Street, the Dow Jones set a new record high yesterday as stocks were boosted by the lower price of crude and renewed optimism that the economy can achieve a soft landing. The Dow Jones jumped 123 points to end the day at 11,850. The Nasdaq was 47 points higher, at 2,290. And the S&P 500 closed 16 points higher, at 1,350.

In Asia, the Nikkei leaped 366 points higher, ending the day at 16,449.

Crude oil climbed back above $60 a barrel in New York late last night, after OPEC announced that it might cut supply in order to boost prices. Crude was trading at $59.81 this morning, and Brent spot was at $58.77 in London.

After falling as low as $559 on Wednesday, spot gold crept back up to $569/oz in the early hours.

And in London this morning, no-frills airline Ryanair revealed that is is to make a 1.48bn euro offer for fellow Irish airline Aer Lingus, having already bought a 16% stake in the company. Aer Lingus currently operates long-haul routes, and if an acquisition is successful, Ryanair could become the first European budget air carrier to operate trans-Atlantic services. 'This offer represents a unique opportunity to form one strong airline group for Ireland and for European consumers,' Ryanair CEO Michael O'Leary announced today. Shares in Aer Lingus were up by as much as 11.1% this morning, whilst Ryanair shares had fallen by more than 2%.

And our two recommended articles for today...

What is the secret of successful investing?

- There's one secret ingredient you can't live without - either in business or the investment markets. Tom Dyson explains what it is, how he found out, and why it means you should hold on to gold right now. Click here: What's the secret of successful investing?

How the US became a bubble economy

- The policymakers are carefully avoiding the 'b' word, preferring to describe the US as an 'asset-driven economy'. But the ugly truth is that the US is now in an economic bubble. How did it get there? And what next? To find out why Dr Kurt Richebacher of The Daily Reckoning thinks the bubble is different this time, read: How the US became a bubble economy