The meltdown in home prices isn't over yet, predicts former Federal Reserve Governor Lyle Gramley.
"I think home prices will continue to decline probably until the middle of next year," Gramley told Moneynews.com in an exclusive interview.
Now a senior economic adviser to financial services firm Stanford Group Company, Gramley says the key question now is, when will credit markets return to normal.
"I really think the issue of when the economy turns around depends very much on credit markets. They've been very dysfunctional since last August, and there are no consistent signs of healing yet," he says.
The economy needs smoothly flowing credit markets to function well, he says.
The Greenspan Federal Reserve helped create to some degree the mess we're in now, but former Fed chair Alan Greenspan cannot be blamed entirely, says Gramley, himself a Fed governor from 1980 to 1985.
"The Fed has a little bit of responsibility for what happened after keeping interest rates too low in 2003 and for not seeing what developed in housing markets in terms of increasing laxity of underwriting standards."
But, he says, "investors around the world were happy to buy sloppily underwritten mortgages, so you can blame them too."
"You can blame credit agencies for not being on top of their jobs too. There is a lot of blame to go around."
Gramley doesn't think the Fed will tighten policy soon, and he agrees with that stance. The Fed this week kept rates steady at 2 percent.
"The Fed's behavior in the last six months indicates clearly that officials think the major danger for the economy now is weakness that could accumulate into quite a downward spiral," he says.
"I don't think the Fed should or will start raising rates until we see credit markets perform better and the economy on a path of growth that can be sustained in the long run."
Bottom line, Gramley says: "I don't think we'll see those conditions until early next year."
As for the dollar, he says the currency's weakness over the past few years is a "double-edged sword." While the greenback's decline has boosted exports and restrained imports, "it adds to inflation pressure," he notes.
"So we don't want to see the dollar fall further at the moment." Indeed, there is room for the greenback to rebound against major currencies like the euro, Gramley says.
The dollar remains overvalued against emerging market currencies, like the Chinese yuan, he says. But adjustment there doesn't have to "happen right away."
Finally, Gramley says that a new round of government regulation is inevitable in the financial sector, given the crisis of the past year.
"I think everyone agrees that's necessary on both sides of the political fence, including the Bush administration and Congress," he says.
"We have to be careful in adopting new regulations that we don't stifle innovation in financial markets," Gramley points out.
"But it's clear that depending on self-regulation and discipline, which we have been doing too much, is simply not enough."
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