The global financial crisis is set to get much worse, with a large U.S. bank failure likely in the next few months, former International Monetary Fund (IMF) Chief Economist Kenneth Rogoff has warned.

Speaking at a conference in Singapore, Rogoff, now an economics professor at Harvard University, said that despite hopes that the U.S. economy had turned the corner, the reality is that “the worst is to come.” And that includes the probable collapse of a “whopper” U.S. bank or investment bank, he said.

“We’re not just going to see mid-sized banks go under in the next few months,” said Rogoff, who held the IMF role between 2001 and 2004. “We’re going to see a whopper, we’re going to see a [failure of a] big one – one of the big investment banks or big banks.”

Rogoff’s comments – reported by Great Britain’s BBC News – coincide with Money Morning’s repeated predictions over the past year that the ongoing U.S. financial crisis would have real staying power. Just this week, in fact, Money Morning featured an exclusive interview with investing guru Jim Rogers, in which the well-known author and commentator said that Americans will be feeling the fallout from this crisis for years to come.

The end of this global financial crisis “is a long way away,” Rogers said. “In fact, it may not be in our lifetimes.”

Dire predictions like those made by Rogoff have been increasing in frequency. Back in June, analysts with the Royal Bank of Scotland Group PLC (ADR: RBS) warned clients to brace for a full-blown crash in the global stock-and-bond markets that would take place within 90 days, as the conflicting realities of slowing growth and rising inflation paralyzed the world’s major central banks. The result: “All the chickens will come home to roost,” the RBS analysts told Great Britain’s Daily Telegraph newspaper.

That report raced across the Internet, although it appeared at the time that European news organizations gave it much greater play than their U.S. counterparts.

The Fed’s Market Missteps

This week’s comments by Rogoff, the former IMF official, came as shares of Fannie Mae (FNM) and Freddie Mac (FRE) sank Monday on a report that the Bush administration wants to nationalize the two mortgage lenders.

In his speech in Singapore, Rogoff predicted that Fannie Mae and Freddie Mac would “probably” not exist in their present form in just a few short years, stating that “we have to see more consolidation in the financial sector before this is over.”

On Monday, shares of Fannie Mae fell more than 22%, or $1.76, to close at $6.15. Shares of Freddie Mac fell almost 25%, or $1.46, to $4.39. Fannie Mae’s shares were down another 1.63% yesterday (Tuesday), closing at $6.05, and Freddie Mac’s shares dropped by another 5.74%.

Shares in Freddie and Fannie plunged in July on investor fears that the two government-sponsored enterprises would run out of money to fund their businesses, which prompted the U.S. government to step in and take radical steps to avert a financial panic.

As mortgage guarantors that are there to pay up when homeowners default on their loans, the two firms have served as the financial backbone of the U.S. mortgage market: Virtually all U.S. mortgage lenders rely on the two to buy up mortgages in order to access the funds to lend to consumers.

With the onset of the subprime mortgage crisis – and the one-two punch of collapsing home values and soaring foreclosures – Fannie and Freddie’s finances have been savaged. That subprime crisis and ensuing global financial crisis has hammered the global credit markets and led U.S. Federal Reserve policymakers to slash the benchmark Federal Funds rate from 5.25% last September all the way down to 2% earlier this year.

But Rogoff has joined the growing list of critics who maintain that it was a major miscue for the U.S. central bank to cut interest rates as “dramatically” as it did. The reason: Cutting interest rates “is going to lead to a lot of inflation in the next few years in the United States,” Rogoff said.

But inflation may still not be the top worry over at the Fed.

On Friday, two top central bank officials predicted a weak second half for the U.S. economy, warning that strong U.S. growth may not return until 2010. Atlanta Federal Reserve Bank President Dennis P. Lockhart and Chicago Fed Bank President Charles L. Evans both said the U.S. central bank is in no hurry to start raising rates while the American economy is sputtering badly because of an ongoing global financial crisis, a sagging housing market and inflationary pressures caused by a yearlong run-up in food-and-energy prices.

In fact, Lockhart even said he wouldn’t rule out actually cutting interest rates if economic circumstances warranted – a remarkable admission at a time when the economic crisis is juxtaposed over rising inflationary pressures, and when most Fed-watchers expect the central bank’s next move to be an increase in interest rates.

A reduction in interest rates would jump-start U.S. growth. But there’s a good chance it would also re-start an escalation in energy and food prices – and a resumption of the bull market in overall commodity prices. Coupled with the ongoing downward spiral in the U.S. housing market, this could signal the return of stagflation for the first time since the 1970s.

There’s evidence this is already happening. Wholesale prices advanced at their steepest annual rate in 27 years last month, while monthly housing starts dropped to their lowest level in 17 years, two separate government reports said yesterday.

In fact, the 1.2% monthly increase in wholesale prices was well above what economists had been anticipating. For the 12 months through July, wholesale prices advanced at a 9.8% annual clip. Prices haven’t increased that steeply since the deep recession of the early 1980s. [For a complete look at yesterday's wholesale pricing and housing reports, check out this related story in today's issue of Money Morning.]

But there may be two opposing schools of thought forming inside the Federal Reserve. Federal Reserve Bank of Richmond President Jeffrey M. Lacker feels the policymaking Federal Open Market Committee (FOMC) might have to boost interest rates before signs of an economic recovery are actually confirmed, Bloomberg News reported yesterday (Tuesday).

“It is important to withdraw this monetary policy stimulus in a timely way,” Lacker said in a Bloomberg Television interview. “That may require us to withdraw before we are certain all of the weakness is behind us and before we are completely certain that financial markets are as tranquil as we would like to see.”

Central bank policymakers signaled two weeks ago that the U.S. financial crisis and the souring employment outlook would delay any increase in short-term interest rates. And those officials – including Lacker – ruled out any potential for rate reductions.

“I certainly don’t think the Federal Funds rate should be any lower, given where we are now,” Lacker said. `Monetary policy is very stimulative right now [and] we are still in a fairly risky situation” on the inflation front.

One last point is worth noting: While Lacker is a voting member of the FOMC, Evans and Lockhart don’t attain that authority until next year.

News and Related Story Links:

• BBC News:
  U.S. bank “to fail within months.”
• Money Morning News Analysis:
  New Report Says Feds Growing Increasingly Likely to Recapitalize Fannie and Freddie.
• Money Morning Market Commentary:
  Subprime Crisis Again in the Spotlight as the Meltdowns of Fannie Mae and Freddie Mac Fuel Fears of a Deeper Downturn.
• Money Morning News:
  Financial Fears Sweep the Globe After RBS Predicts Worldwide Stock-Market Crash.
• Wikipedia:
  International Monetary Fund.
• Money Morning Economic News:
  Top Federal Reserve Officials Predict Weak Second Half; Warn Growth May Not Return Until 2010.
• Money Morning Economic News:
  Super-Sized Rate Cut Spurs Super-Steep Rally; Dow Soars Nearly 336 Points.
• The New York Times:
  Wholesale Prices Jumped in July.

In part because of the U.S. market’s economic malaise, the International Monetary Fund (IMF) cut its global growth projections for next year from 5.2% to 4.8%, Bloomberg News reported.

In its semiannual World Economic Outlook, the IMF scaled its prediction for U.S. economic growth back to 1.9% from 2.8%. Declining home sales, rising mortgage defaults, and tighter credit conditions will no doubt "extend the decline in residential investment," in the U.S. economy, and could pose a serious threat to household spending.

Evidence of the U.S. economic expansion continuing "below trend would justify further interest rate reductions provided that inflation remains contained," the report said. In calculating its estimate, the IMF assumed the U.S. Federal Reserve would cut interest rates by another half a point by the end of the year. It also anticipates that both the European Central Bank and the Bank of England will hold their rates steady. 

However, "robust" growth in China, India, and Russia accounted for half of worldwide growth over the past year, and should be enough to counterbalance the pullback in America, the report said.

The IMF cut its growth estimate for the 13-nation euro region to 2.1% from 2.5%.  Japan’s GDP is expected to slow from 2% to 1.7%.  China, India, and Russia are all expected to maintain their high levels of growth. The IMF has penciled China in for 10% growth in 2008, after this year ranking Number One in global growth for the first time ever – thanks to an expansion rate of 11.5%. India should record growth of 8.4% in 2008 and Russia 6.5%, the IMF predicts. 

Overall, the IMF said that high oil prices and rising commodity prices could jeopardize global growth.

 "Global oil markets are very tight," the report said. "Oil prices are likely to remain high in the absence of further change in OPEC’s quota policies or a major global slowdown."

Another key worry: "Heightened geopolitical concerns could lead to further price spikes that could quickly translate into higher headline inflation."

The IMF singled out emerging markets as the most immediate risk, because of a heightened vulnerability to spikes in food prices.

News and Related Story Links:

• Bloomberg:
  IMF Cuts World Growth Forecast, Warns of Market Risks.

• Money Morning News:
  China: Bubble or Bull Market?

• Money Morning News:
  Japan’s Politics Shouldn’t Derail Its Economy: Profiting from the New Prime Minister.

• Money Morning News:
  U.S. Economy Surges in the Second Quarter, Struggles After That.

• Money Morning News:
  European Finance Minister to Study U.S. Economic Woes.