The Fed to the rescue II: Waiting for the other shoe to drop

In my column two weeks ago, “The Fed to the rescue,” I discussed the US Federal Reserve Bank’s cutting of the discount rate, the rate it charges for giving direct loans to banks, from 6.25 percent to 5.75 percent.

The Fed’s action was directed at the turmoil in financial markets that resulted from the sub prime mortgage crisis (see my column “The emergence of the Turkish mortgage market.”) However the financial markets, regarding the discount rate cut as temporary relief, have been expecting the Fed to drop the other shoe by cutting the target federal-funds rate -- the interest rate banks charge each other for overnight loans to meet reserve requirements -- by at least 0.25 percent from 5.00 percent, to complete its rescue mission. The target federal-funds rate has a much more important effect on the US economy than the discount rate, by determining the prime lending rate US banks charge their preferred customers, which in turn becomes the benchmark interest rate for all other consumer and business loans. That rate, in turn, can have an effect on short-term interest rates and exchange rates globally.

The Fed has not yet dropped the other shoe, despite persistent global financial instability driven by increasing risk aversion and uncertainty about the damage caused by the sub prime mortgage debacle. But it has implicitly signaled its pragmatic position and addressed again the concerns of financial markets through a much-anticipated speech Fed Chairman Ben Bernanke gave last Friday morning, at the Federal Reserve Bank of Kansas City’s annual economic symposium in Jackson Hole, Wyoming, during a high-level international meeting of central bankers and economists to discuss recent developments in the housing and housing finance markets. Bernanke devoted most of his speech, titled “Housing, Housing Finance, and Monetary Policy” -- his first public statement in six weeks -- to reviewing the causes of the US housing market crisis and its sub prime-mortgage-securitization based, contagiously destabilizing effects on global financial markets within the historical context of the US housing and housing-finance markets. What most people really cared about, however, was not the former economics professor’s lecture (with 15 references and 10 footnotes) on the evolution of the US housing and housing-finance markets. It was his explanation of the rationale behind the Fed’s recent actions to ease turbulence in financial markets and his hinting at what follow-up actions it might take, especially the cutting of the federal-funds target rate soon.

Bernanke acknowledged that financial market stability was one of the Fed’s major objectives: “Well-functioning financial markets are essential for a prosperous economy. As the nation’s central bank, the Federal Reserve seeks to promote general financial stability and to help to ensure that financial markets function in an orderly manner.” He also warned, “It is not the responsibility of the Federal Reserve -- nor would it be appropriate -- to protect lenders and investors from the consequences of their financial decisions.” He also told the financial markets not to expect a “Bernanke put,” similar to the “Greenspan put,” which refers to former Fed Chairman Alan Greenspan’s lowering of short-term interest rates in previous financial crises. (A put is an option that gives the holder of the option the right, for a premium, to sell a security at a predetermined price within a given period.) Bernanke weakened his stern position, however, with the following statement: “But developments in financial markets can have broad economic effects felt by many outside the markets and the Federal Reserve must take those effects into account when determining policy.”

So, please give us a clue, Mr. Chairman, as to under what conditions, if not when, the Fed would cut the target federal-funds rate. Well, the Fed would look at the condition of the real economy, which was doing reasonably well: “The incoming data indicate that the economy continued to expand at a moderate pace into the summer, despite the sharp correction in the housing sector.” Given the extraordinary turbulence and uncertainty in financial markets, however, the Fed would not be bound by its business-as-usual methods of following and correcting the course of the real economy: “However, in light of recent financial developments, economic data bearing on past months or quarters may be less useful than usual for our forecasts of economic activity and inflation. Consequently, we will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country.” In plain words, the Fed would be flexible and pragmatic and might cut the target federal-funds rate just to be on the safe side -- for the sake of the real economy (the Main Street) but not Wall Street -- when its Federal Open Market Committee, which decides the target, meets on Sept. 18.

US financial markets acknowledged this hopeful message with across-the-board rallies on the day of Bernanke’s speech. On Friday US stock prices went up and bond prices went down by amounts revealing traders’ cautious optimism, but not giddy exuberance. The markets also factored in the Bush administration’s encouraging announcement, also made on Friday, that the Federal Housing Administration would help ameliorate the sub prime mortgage crisis by limiting the number of foreclosures and helping borrowers with adjustable interest rates to refinance their mortgages.

The most recent monthly data show US core consumer inflation to be under control, well within the Fed’s one to two percent implicit target, and US consumer confidence to be slightly weakening, conditions reinforcing the chances of a federal-funds target rate cut next month. Although futures contracts traded on the Chicago Board of Trade -- through which traders bet on the expected monthly average effective federal-funds rate -- have already priced in a quarter percent target rate cut for next month, economists disagree on whether the Fed would actually cut its target. I still do not expect the “Bernanke put” to follow in the steps of the “Greenspan put,” if conditions in financial markets do not drastically worsen and the US real economic growth does not slow down suddenly, for the following reasons: (1) The most recent quarterly data on US economic growth show surprisingly robust performance. (2) The Bush administration has begun to address the sub prime mortgage crisis from the viewpoint of borrowers. (3) The fact that banks have significantly reduced their borrowing last week from the Fed’s discount window, after the Fed made its loans more available and attractive two weeks ago, indicates that credit markets have already calmed down considerably. If necessary, the Fed could cut the discount rate again, bringing it down closer to the current target federal-funds rate, to ease credit tightening. (4) Dr. Bernanke has to live down his early unsavory reputation as “Helicopter Bernanke,” for having suggested as a professor that the Fed could drop money from a helicopter to help prevent a potential deflation. (5) He must also rectify the Fed’s impaired rectitude arising from his predecessor’s laxness in easing credit for too long -- which is blamed for many of the present credit market problems -- to contain earlier financial crises. Bernanke, who has been at the helm of the Fed for less than two years, has to secure his reputation as an inflation hawk by embracing the financial markets with tough love. I hope that he will not be a clone of Greenspan, whose indulgent love for the financial markets left behind an increasingly questionable legacy after being adulated by some hyperbolically as “the greatest central banker of all time.”
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