In investing, a little fear is a good thing. But too much of it can bring a financial market to its knees. When investors began to shun the debt of perfectly sound companies in the commercial- paper market on Aug. 16, the Federal Reserve basically said: "Enough already!" The next day it announced new and innovative steps to restore liquidity to an arid financial system that was too dry to function properly.
With fear and uncertainty usurping reason and fundamentals, the Fed gave banks an historically wide latitude to borrow directly from the central bank, in an effort to shore up credit availability and preempt the kind of financial panic that could kill off economic growth in the U.S. and damage a healthy global economy. On Aug. 21 it took an additional step to provide more liquidity by cutting a key rate that big bond houses pay to borrow Treasury securities.
The question now: Will the strategy work? Or will the Fed have to pull out its big gun and cut its target rate for all borrowing throughout the economy? Investors are betting heavily that the policymakers' recent actions foreshadow a broader easing. Right now, the futures markets expect the Fed to cut its target rate for federal funds—those that banks borrow overnight from each other—to about 4.5% by yearend, from 5.25% now. As of Aug. 22, the markets saw no chance policymakers will leave the rate unchanged at its Sept. 18 meeting.
DESPITE THOSE ODDS, however, a rate cut is still no sure bet. What is happening—so far—is a liquidity crisis, not an economy crisis. Fear and uncertainty have heightened demand for cash, and there's not enough of it to go around. Clearly, with events still so unsettled, the first sort of crisis could easily morph into the second, but if the Fed's latest temporary moves are successful at mitigating the liquidity and credit problems, there will be no need for a broader easing in policy, and the economy will most likely escape with only small scratches.
Based on the Fed's statements as late as its Aug. 7 meeting, policymakers will not hastily abandon their belief that future inflation is their "predominant policy concern." Even if the Fed shifts its stance to say a weak economy is now its chief worry, that doesn't automatically imply a rate cut, just as its recent inflation concern didn't presage an immediate rate hike. The policymakers' statement accompanying the Fed's Aug. 17 action said: "The downside risks to growth have increased appreciably," suggesting the Fed now sees the balance of risks between inflation and recession as more even.
The Fed's focus right now is on the financial markets. A fix targeted there removes the threat to the economy. The recent moves may well hit the bulls-eye, though they will not work overnight as institutions adjust to the new procedures.
THE AUG. 17 ACTION is unique and extends well beyond a typical cut in the discount rate, which makes it cheaper for banks to borrow emergency funds from the central bank. In addition to slashing that rate, from 6.25% to 5.75%, the Fed also extended the term of these loans, from the traditional overnight period to 30 days, and that term is renewable by the borrower. The Fed is also accepting a broad range of types of collateral—even certain subprime mortgage loans. And all banks have been given the green light to use the discount window. The Fed has communicated to banks that no stigma will be attached to strong banks that borrow from the Fed, an activity that during normal times has been associated only with distressed banks in weak financial condition.
A number of hedge funds and mortgage lenders could be key beneficiaries of the Fed's strategy, if not directly, then indirectly: Given the ability to borrow from the Fed stigma-free, banks may be more willing and able to fund some of these liquidity-challenged institutions, which could relieve stress on the overall financial system.
Based on the Fed's latest survey of senior loan officers, banks were more than willing to lend to their corporate customers, at least based on responses through July 26. The data showed only a slight rise in the percentage of banks tightening their lending standards for commercial and industrial loans, from 3.7% in the April survey to 7.5%. Those are very low levels by historical standards. In household lending, banks had already strongly tightened their standards for subprime mortgages in the April survey, but they raised the bar much less for prime loans. And the latest sampling showed no additional squeeze.
WHAT'S BEEN LOST in the financial panic of recent weeks is that the economy headed into the third quarter under a rising head of steam. Consumer spending is perking up after a second-quarter slowdown. Capital spending by businesses is also gaining strength. Manufacturing activity is chugging along at a good clip, powered in large part by strong demand for exports. The latest reports imply that the economy grew better than 4% in the second quarter, far stronger than the 3.4% pace the government first estimated.
The events in the credit markets to date are sure to take a nip out of growth in the second half. However, barring the kind of systemic financial meltdown the Fed is now trying to prevent, the biggest hit will be to housing, where the credit constraint is concentrated. Because there's less mortgage money, homes sales and housing starts will be weaker, and inventories will rise further, putting more downward pressure on prices. The new downturn in homebuilding is already showing up. July housing starts dropped 21%, measured at an annual rate, below the second-quarter's average. Starts last quarter had actually stabilized.
The spillover of credit woes to other sectors should be much smaller. Consumer and business confidence are sure to get hammered, but the supports under both sectors will not erode nearly as much. The July advance in retail sales means consumer buying began the third quarter on a solid note, and the government revised retail outlays in May and June appreciably higher. Household balance sheets are at risk from falling stock prices and home values, but the drop in gas prices since May will boost buying power, and incomes are supported by strong job markets.
As for businesses, they are coming off a healthy gain in second-quarter profits: more than 8% for firms in the Standard & Poor's 500-stock index. Inventories are trim, and overseas demand is booming. Exports in May and June posted the best two-month gain in more than three years. Also, capital-goods production has lead the strong gains in manufacturing output through July, suggesting companies are expanding their operations.
Of course, all these solid fundamentals could crumble under the impact of some new and powerful wave of financial-market distress. In that case, the Fed will have no choice but to slash interest rates broadly. However, the central bank has reacted quickly and innovatively to the current problems. That, plus the underlying health of the U.S. and global economies, should eventually ease investors' fears and help the markets return to normal.
By James C. Cooper