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The Fed's Mild Medicine


Its plan may give some relief to banks but won't do much to revive growth

Give Federal Reserve Chairman Ben S. Bernanke an "A" for creativity. As the credit crunch worsened this fall, Bernanke saw a financial system in shock but an economy that seemed relatively healthy. He wanted to restore confidence in the banks without flooding the system with money, which would risk an outbreak of inflation.

His solution: First, on Dec. 11 the Fed cut rates by a modest quarter point. Then on Dec. 12 the central bank unveiled a brand-new monetary tool—a periodic auction of loans to banks. These will be secured by a wide variety of collateral, including mortgage-backed securities. By lending freely to beleaguered banks, the Fed is sending a signal: We won't let this credit crunch spiral downward into an outright crisis.

Whether it works depends on how you define success. The so-called Term Auction Facility should help relieve the stresses in the financial system that have left banks afraid to lend even to one another because they don't trust the quality of borrowers' collateral. With the Dec. 12 announcement, the possibility of a financial-sector meltdown has diminished.

For the overall economy, though, it's no miracle cure. It's specifically not intended to expand the supply of money in the economy. And it does nothing to strengthen banks' weakened balance sheets. So even with the new Fed backstop, lenders may remain reluctant to lend. To revive economic growth, more action will likely be required: bigger rate cuts, stronger government measures to clean up the subprime debacle, or some combination of the two.

How It Will Work

In keeping with the Fed's discreet ways, Bernanke didn't stage a press conference to announce the Term Auction Facility. Two senior Fed officials briefed reporters on background. The Fed will lend up to $20 billion at each of two December auctions, with two more scheduled for January. Rates will be set through bidding. They probably will be at least as high as the federal funds rate, which banks charge each other for overnight loans of reserves, but lower than the discount rate the Fed itself charges for loans.

The key is that the Fed will lend to any healthy bank and will accept many types of collateral, perhaps placing a higher value on it than the banks would be able to get on the open market. The Fed also arranged to swap currencies with the European Central Bank and the Swiss central bank, allowing those institutions to lend up to $24 billion to banks that have trouble borrowing dollars on the open market.

The market's reaction to the Fed's latest actions was mixed to negative. With fears of a 2008 recession on the rise, stocks plunged on Dec. 11 after the Federal Open Market Committee announced the reduction of the federal funds rate to 4.25%, as well as a quarter-point cut in the discount rate, to 4.75%. Traders thought there was a good chance that the Fed would cut the discount rate by a half point, and some were holding out hope for a half-point cut in the funds rate as well. The Dow Jones industrial average fell 294 points, or more than 2%.

Markets weren't charmed by the Fed's latest innovation, either. Stocks surged at the opening on Dec. 12 after the Fed announced the loan auction, regaining almost all of the previous day's loss. But the market surrendered most of its gains after details emerged.

Not Enough?

What's becoming clear is that market frenzies take their own course, and there's no easy remedy. The core problem remains: Many banks loaded up on iffy assets such as subprime loans that are continuing to lose value as the U.S. housing market keeps sinking. They're reluctant to make new loans because they don't trust their borrowers, and they want to husband their cash in case they have to make further writedowns. The Fed's Dec. 12 plan, while it should ease stress in the system, "does not fix in any shape or form the source of the problem," says Lena Komileva, Group G7 economist for Tullett Prebon, an interbank broker.

With the economy slowing, Bernanke & Co. will probably have to cut the fed funds rate again, though they may not like it. If rates fall far enough and stay down long enough, they will stimulate growth by encouraging more purchases of cars, houses, and business equipment, notes Laurence M. Ball, an economist at Johns Hopkins University. How far down? Goldman Sachs (GS) Chief Economist Jan Hatzius, one of the most bearish figures on Wall Street, expects the Fed to cut the funds rate to 3% by mid-2008, 1.25 percentage points below its current level.

But more money alone won't be enough. It will have to be coupled with strong action to clean up the bad debts on bank balance sheets. As the Japanese discovered in the slow-growth lost decade of the 1990s, banks won't extend new credit, even when their borrowing costs are superlow, if they are preoccupied with rolling over bad debt. The Bush Administration initiative to provide relief to some subprime mortgage borrowers goes only partway to coping with the debt overhang. The Fed's latest plan will help as well—but in the end, a lot more will be needed.

Coy is BusinessWeek's Economics editor.

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