With U.S. financial markets under their most severe stress in years, if not decades, the smart money was on the Federal Reserve to cut interest rates on Sept. 16. The smart money was wrong. Defying expectations on Wall Street, Chairman Ben Bernanke and his fellow rate-setters on the Federal Open Market Committee left the federal funds rate unchanged at 2%.
Why? Because the Fed decided that a rate cut was the wrong treatment for the ailing patient. Instead of making loans cheaper, the Fed is focused on the very different task of making loans more widely available. The key problem in the credit crunch, as the Fed sees it, is that lenders are hoarding cash and refusing to lend to one another at any rate. So it's stepping up its own efforts to serve as a lender of last resort, supporting institutions that have trouble getting money anywhere else in the current panic.
In quieter times, economists pay a lot of attention to conventional indicators like unemployment and inflation. But right now, the key indicator for economists inside and outside the Fed is the health of the financial system. Because credit is the lifeblood of the economy, and if it dries up all bets are off.
One measure of how chaotic things have gotten is the huge swings in the rate that banks are actually paying for federal funds, vs. the 2% target that the Fed is aiming for. Federal funds are simply dollars that banks borrow from each other in overnight loans to bolster their reserves at the Fed. On Sept. 15 that rate swung all the way from a low of 0.01% to a high of 7%, according to the Federal Reserve Bank of New York. "The interbank market is dysfunctional right now," says Lou Crandall, chief economist of Wrightson ICAP, the New York research arm of London-based broker ICAP (IAP.L).
Even though the Fed isn't cutting rates, it's working hard to bring stability to the financial markets. Timothy Geithner, president of the Federal Reserve Bank of New York, has been in daily meetings with leaders of key players, including embattled American International Group (AIG). At the same time, the New York Fed is making lots of loans through its so-called discount window. Also, the Fed injected a bigger-than-usual $70 billion into the banking system on Sept. 15 to satisfy a cash-hoarding surge among banks. It pumped in a further $50 billion the next day. Crandall said the Fed "supplied the banks with more reserves than they will need for weeks to come."
The Federal Open Market Committee chose not to call attention to the Fed's central role in stabilizing the financial markets. Instead, its statement focused on the traditional issues. It acknowledged growing troubles in the financial and labor markets but said: "The downside risks to growth and the upside risks to inflation are both of significant concern."
Wall Street took the Fed's action—or nonaction—in stride, possibly reading its refusal to cut rates as a signal that the financial situation is less dire than feared. The Standard & Poor's 500-stock index fell about 1.5% immediately after the Fed's early-afternoon announcement but then bounced upward. Helping the market in late trading was the prospect that the Fed would lend money to AIG (BusinessWeek.com, 9/16/08). The S&P closed the session with a gain of 1.7%, to 1213.60, up from 1192.70 on Monday.
The Fed's continued "significant concern" with inflation was the biggest surprise in its announcement, because headline inflation numbers have turned extremely mild. Earlier in the day the Labor Dept. announced that the consumer price index actually fell 0.1% in August, led by a steep decline in energy prices. After hitting $147 a barrel in early July, crude oil has plummeted on concerns that a global economic slowdown will decrease demand. On Sept. 16 oil fell $4.91, to $90.80 a barrel, on the New York Mercantile Exchange.
A Very Active Fed
In a week of deep uncertainty on Wall Street, the Fed is doing plenty to keep the gears turning in the financial system, even though it didn't cut rates. The Fed's $120 billion injection of funds over two days limited a spike in the federal funds rate, which is the rate that banks charge each other for overnight loans.
Analysts said that by voting against a rate cut, the Fed seems to be focusing on ensuring that borrowing is freely available, rather than making borrowing cheaper. Stuart Hoffman, chief economist of PNC Financial Services Group (PNC), said in an interview that cutting rates would have been "the wrong weapon aimed at the wrong target." Paul Ashworth, senior U.S. economist of Capital Economics, said in a statement after the vote: "The Fed is now more than ever determined to tackle the funding problems in financial markets by widening the scope of its liquidity programs rather than lowering interest rates."
In this credit crunch the Fed has vastly expanded its lending programs, accepting more kinds of assets as collateral and opening lending to investment banks for the first time. It's even accepting stocks as collateral for the first time. What it's not doing, right now, is cutting the federal funds rate. "The fact that they were balanced in their view of the risks tells me that this group does not believe that the problems in the financial sector are going to crash the economy," says Joel Naroff, president of Naroff Economic Advisors in Holland, Pa.
But if the credit crunch causes further weakness, the Fed is likely to be forced to cut the federal funds rate. That would stimulate households and businesses to spend more. Hoffman, the PNC economist, said: "They've at least opened the door to a rate cut, even if they're not ready to step across the threshold."