The Fed's Move: More Than a Symbolic Gesture

S&P says the discount-rate cut has reduced the risk that the credit crunch could send the economy into a downward spiral

The Federal Reserve cut its discount rate -- the rate for borrowing from the Fed, and provides temporary liquidity support to banks -- by 0.50 percent on Aug. 17 to 5.75%. The move does not affect the federal funds rate, which remains at 5.25%. The move is intended to free up liquidity support for the commercial paper market, which has dried up because of the general credit squeeze, reports S&P MarketScope, providing what should be direct support for Countrywide (CFC) and other beleaguered firms.

The Fed's action caused S&P 500 futures, which had been down as much as 18 points, to rise to a gain of more than 30 points almost immediately after the action and issued statement. In early trading, the S&P 500 was up 31 points before retreating somewhat later in the morning.

The equity markets responded so favorably to the Fed's action, in my opinion, because it sent a message to investors that the Fed will do whatever it can to alleviate the lending paralysis brought on by the fear surrounding the spread of the sub-prime worries.

David Wyss, S&P's Chief Economist, said "I believe the Fed's actions are not just symbolic – there is real meat here." While the lowering of the interest rate was important, Wyss says the opening of the lending window for 30 days was key. Usually it is limited to a week, even though the Fed can extend this timeline. With the extension, says Wyss, "the Fed effectively told banks that we know this is an emergency, so we won't judge you for asking for a loan."

Wyss also said "The Fed has performed monetary surgery with a scalpel rather than a sledge hammer, as it addresses the short-term paper market, not the overall cost of borrowing." He believes the action reduces the overriding worry that the mortgage market would grind to a halt. Further, says Wyss, it buys the Fed time to assess the situation and possibly not act on the Fed funds rate until September.

Accompanying the Fed's action was the statement: "Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward." In addition, they said "The Federal Open Market Committee judges that the downside risks to growth have increased appreciably," finally admitting to what everyone has known for the past four weeks.

Upon reading this, I cursed our automated society as instant information and analysis now allow us to experience both fear and greed at the exact same moment. I wondered if the statement would raise the eyebrows of the skeptical "recession rangers," causing them to become increasingly alarmed of a pending economic slowdown, and possible recession, since the Fed is now acknowledging that the subprime worries have indeed spilled over onto the general economy (which they earlier said would not).

Again Wyss was reassuring, as he stated that the Fed's actions reinforced his conviction that the economy will recover in 2007 and 2008 as he forecasted previously. In particular, "it has reduced the risk that the credit crunch could send the economy into a downward spiral." I'll keep my fingers crossed.

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