In these grim times, one of the few sources of optimism about the outlook for the US economy has been the idea that, thanks to lower interest rates, financial conditions are getting a lot easier. According to economic theory and common sense (not always the same thing), that should mean that over the next year or so — these things tend to work with a bit of a lag — demand will recover as businesses and consumers are attracted by lower interest rates to borrow more money. It is the basic assumption that is underpinning the view that, even if the economy is in recession, growth should accelerate later this year.

But what if, despite the Federal Reserve's 225-basis-point reduction in interest rates over the past five months, financial conditions are actually still getting tighter? How much further damage might there be to the economy then?

The credit crunch induced by the sub-prime mortgage debacle was supposed to be easing by now. Yet there are increasingly worrying indications that it might be getting worse.

The economists at Citigroup in New York compute an index of overall financial conditions in the economy that measures not only official interest rates but all kinds of variables, such as asset prices, credit spreads and other exotica. The latest Citigroup index shows that there has been a sharp deterioration in conditions since the Fed began to cut rates last autumn. Back in October, at what was then thought to be the worst moment in the credit crunch, Citigroup's index suggested that conditions overall were about neutral — neither stimulative not accommodating. Last week the index had dropped to its most negative level in more than five years. Despite the rate cuts, Robert DiClemente, Citigroup's chief US economist, estimates that the index is consistent with an 80 per cent probability of a recession.

How can this be, given that interest rates are much lower — not only official rates but ten-year bond yields and most other market rates? The problem is that conditions are deteriorating on so many fronts that the official interest-rate cuts have been overwhelmed by negative movements elsewhere. Equity prices have declined, raising the cost of capital for businesses. Falling property prices have significantly eroded the value of household balance sheets.

And then, of course, there is the blunt reality of the credit crunch — the increasing reluctance of banks to lend money, even to relatively creditworthy customers. Last week the Fed published its quarterly survey of lending officers at commercial banks around the country. Almost one third of these lenders said that they had tightened their credit standards for loans to all categories of business customers — small, medium and large.

More intriguing was the reason these bankers gave for their greatly reduced willingness to advance loans. It was not, they said, because of any capital or liquidity concerns at the bank itself, but primarily because of rising concerns about economic conditions that could adversely affect the borrowers' ability to meet their obligations.

This suggests that the economy may now be in the grip of a vicious circle. The initial credit tightening from last autumn seems to have led to a sharp drop in confidence and a slowing in economic activity. But this, in turn, has made lenders much more reluctant to extend loans, even to high-quality borrowers.

On top of that, we got word at the weekend from a blue-ribbon international gang of central bankers and regulators that we could be in for a repeat of last year's credit turmoil. The Financial Stability Forum noted in its interim report on the functioning of credit markets that the financial system remains very fragile. “It is likely that we face a prolonged adjustment, which could be difficult,” the report said.

In the past week there have been worrying indications of serious renewed deterioration in some credit markets. Most strikingly, things have got alarmingly weak in the market for so-called leveraged loans — low-rated corporate borrowing popular during the private equity buyout binge of the past few years. The Standard & Poor's index that measures the price of these high-risk loans fell last week to a record low of just over 86 cents on the dollar.

Unless conditions improve suddenly, and there is little reason to expect that to happen, the Fed is going to have to press much harder on the interest rate accelerator if it wants to impart more speed to the economy. The central bank's key interest rate, the Fed Funds target rate, is at 3 per cent and there is a lively debate within the Fed about whether it should cut again. Some policymakers are worried they may have already done too much, given that inflation remains a threat.

But if the credit crunch is about to get worse, this will be no time for judicious caution.

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