Morgan Stanley economists see increasing downside risks to the U.S. economy, and say the U.S. Federal Reserve Board will likely be unable to raise rates to combat inflation as a result.

“Despite a rescue package from the Treasury and the Fed, ongoing losses in mortgages and uncertainty about the ability of the housing Government-Sponsored Enterprises (GSEs) — Fannie Mae and Freddie Mac — to provide support for mortgage markets could tighten financial conditions another notch,” they say in a research note. “Together with other economic headwinds, such as slowing global growth and high energy prices, these developments increase downside risks to U.S. economic activity.”

They note that the recent actions by the Treasury and the Fed to provide the GSEs with short-term liquidity and create a vehicle for a capital injection of public funds “should limit systemic threats to the financial system”.

However, it adds that these efforts don’t directly address the economic fallout from additional financial restraint. “In our view, that is a key reason why Fed Chairman Ben Bernanke expressed more caution about the outlook for U.S. growth this week than did the FOMC’s statement of three weeks ago,” it says.

“Along with the upswing in inflation expectations, these developments intensify the Fed’s policy dilemma and seem likely to keep monetary policy on hold for the foreseeable future,” the firm predicts.

“For investors, two implications stand out. First, despite rising inflation expectations, these developments mean that the Fed isn’t likely to tighten monetary policy soon, a view that is gaining currency again. This implies that the yield curve may resteepen and that the dollar will soften,” it says.

“Second, support for the GSEs means that the authorities will continue to protect the financial system from systemic shocks, but they will not protect individual institutions and their shareholders from suffering losses as the credit cycle unfolds. Losses at financial institutions mean erosion of capital and more capital raising and thus shareholder dilution. Investors should continue to favor debt over equity in financials,” it concludes.