The Fed's Plans for Dousing the Fire

Greenspan & Co. prepare for the worst-case scenario

In the ideal world of Federal Reserve Chairman Alan Greenspan, a war with Iraq would be a walkover. In its wake, oil prices would plunge and stock markets would rally. The resulting boost to confidence would snap the U.S. and world economies out of a soft spot and set the stage for a robust recovery.

Now here's the nightmare that Greenspan and his fellow economic policymakers from the U.S., Europe, and Japan know they must prepare for: a protracted war with Iraq, punctuated by massive terrorist counterattacks against the U.S. and its allies -- all sending shock waves through energy, financial, and currency markets. In the unlikely event of such a scenario, Greenspan & Co. are putting in place contingency plans to restore calm to the markets and to shelter the world economy from a financial meltdown. The three-pronged strategy: Flood the economy with money to keep financial markets functioning, cut interest rates to spur growth, and intervene in the currency market to avoid a diving dollar.

There's no guarantee these remedies would work, of course. A protracted war with Iraq could lead to a crisis of confidence in the U.S., throwing the markets into turmoil and overwhelming the Fed's efforts to protect the economy from the fallout. In a speech on Mar. 10, St. Louis Fed President William Poole singled out U.S. mortgage giants Fannie Mae (FNM ) and Freddie Mac (FRE ) as two potential stress points, arguing that they lack enough capital to weather a crisis-induced cash crunch. Both dismissed the fears as overblown.

With the stakes so high, it's no wonder the Fed is ready to take extraordinary measures in the event of a crisis. The first step: opening up the monetary spigots, just as it did after the September 11 terrorist strikes. The Fed would immediately cut the discount rate it charges on loans to commercial banks. Since January, that rate has stood at 2 1/4%, one full percentage point above the level that the Fed pegs short-term interest rates in the interbank money market. By slashing the discount rate, the Fed would signal its eagerness to lend the banks all the money they need.

The Fed would likely also lower the interbank, or federal funds, rate, perhaps in tandem with the European Central Bank. The ECB trimmed its key refinancing rate by 25 basis points, to 2.50%, on Mar. 6, and analysts expect it to cut again if war breaks out.

Such coordination would extend to the currency markets as well. Although the Bush Administration is ideologically opposed to foreign exchange intervention, officials say they are ready to work with allies to stabilize currency rates, should the market become chaotic. That could prove crucial if a terrorist strike in the U.S. leads to a dollar rout.

The Fed even has emergency relocation plans. September 11 forced the New York Fed to move its open market desk, which is responsible for managing the flow of money to and from the markets, from Manhattan to an office in East Rutherford, N.J. Should East Rutherford go down, another Reserve Bank outside New York can take over.

Private financial institutions also have taken steps to prepare for war or terror-related shocks, but they still have a ways to go. The Bank of New York (BK ), hit hard by September 11, aims to move 1,500 employees to a location outside Manhattan, but it won't be finished until next year. The New York Stock Exchange, which closed for four days after the Twin Towers collapsed, has also shored up its operations, including establishing a backup trading facility. The NYSE says it's prepared for any eventuality, but critics say it lacks the skilled personnel needed to make the backup location viable.

As the world fretfully awaits the start of the long-anticipated war with Iraq, financial regulators and monetary policymakers are attempting to follow a tried-and-true formula: hoping for the best, but preparing for the worst. In an increasingly risky and interconnected world, that's an ever-growing task.

By Rich Miller in Washington, with Marcia Vickers and Heather Timmons in New York and David Fairlamb in Frankfurt

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