Commentary: Kid Gloves At The Fed

The perils of overtightening could be dire

Back in February, 1994, when the Federal Reserve began jacking up interest rates, bond traders went berserk. Prices plunged as shocked speculators sold off bonds. In the ensuing carnage, several hedge funds went belly-up, and Orange County, Calif., went into bankruptcy.

Now, as Alan Greenspan gets ready to lead the Fed through another tightening, the dangers posed by a financial backlash are much greater than they were a decade ago. That's because just a few firms dominate far larger markets for housing finance and derivatives. If a sudden rate rise upended one of those big players, the jolt to the financial system and the economy could be much more damaging than anything seen in 1994. Concentration "increases the vulnerability of the system to disruption," New York Fed President Timothy F. Geithner warned bankers on Mar. 25.

So it's no wonder that Chairman Greenspan and his colleagues are going out of their way to prepare investors slowly for tighter credit. In a May 4 statement, the Fed signaled clearly that rates are headed higher, perhaps starting this summer. But it also sought to assure investors that the move would be gradual -- nothing like 1994, when it raised rates three percentage points in a year.

The go-slow strategy also has risks. Inflation is already rising, with consumer prices jumping at a 5.1% annual rate in the first quarter. "The perception is developing in the markets that the Fed is behind the curve," says former Fed Governor Lyle E. Gramley. If that takes root, bond-market vigilantes could drive long rates up faster than the Fed wants.

But Greenspan and many of his colleagues think that fears of higher inflation are overblown and are offset by risks that rapid tightening could spark financial turmoil and damage the economy. The mortgage market may present the greatest peril because of its domination by two big firms, Fannie Mae (FNM ) and Freddie Mac (FRE ). Together, they own or guarantee about 70% of mortgages outstanding.

While the pair try to limit their exposure to rate changes by using derivatives, including interest-rate swaps, there's only so much they can do to shield themselves. "If interest rates change rapidly or unexpectedly...[there's a risk] of an insolvency or at least an illiquidity in these large agencies," Fed Governor Ben S. Bernanke told reporters on Apr. 23. If that happened, the mortgage market -- which provides finance for America's homeowners -- would be thrown into turmoil.

Concentration is a concern in the over-the-counter derivatives market, too. Seven banks, led by J.P. Morgan Chase & Co. (JPM ), hold $68 trillion of the $71 trillion in outstanding paper. Greenspan confessed last year that such concentration gave him "pause" and worried aloud how the markets would cope if one firm suddenly had to close up shop.

Of course, the Fed's primary job is still to head off inflation. But Greenspan figures that productivity growth and slack labor markets will keep price pressures in check and buy him time to gradually squeeze excess credit out of the financial system. It's a calculated gamble. But with markets more vulnerable than ever, it's a risk he may have to take.

By Rich Miller

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