In yet another attempt to improve liquidity for U.S. banks struggling to stay on their feet amid a tidal wave of souring debt, the Federal Reserve's Federal Open Market Committee on March 18 cut both the federal funds and interest rates by 75 basis points each.
Markets remained firmly in positive territory on the news that the federal funds rate had been slashed to 2.25%, despite comments from the Fed that inflationary risks had increased since the FOMC's January meeting. The discount rate remains 25 basis points above the fed funds rate, at 2.50%.
"Uncertainty about the inflation outlook has increased," the FOMC said in a March 18 release. "It will be necessary to continue to monitor inflation developments carefully."
The move comes just two days after the Fed opened its discount window to investment banks and cut the discount rate by 25 basis points, as Wall Street icon Bear Stearns Cos. Inc. collapsed spectacularly. The barrage of tactics employed by the Fed to boost liquidity in markets this year has been staggering — an emergency interim rate cut in January, followed by another round of cuts one week later and the introduction of a $200 billion Term Securities Lending Facility in early March. While the Fed's actions have helped prevent a major stock market crash, many industry observers believe that actions addressing liquidity alone will be insufficient to help banks and investment companies deal with debt securities that appear increasingly sour.
As the August 2007 credit crunch has snowballed into what many believe to be a full-scale recession, some experts are wondering if the Fed's actions are merely prolonging the agony.
"I think they are in a very sticky situation, but it's not one that can be cured just by flooding the market with cheap money," Stanford University Law School professor Kenneth Scott told SNL. "The parallel that comes to mind that I hope is not a parallel is to the Japanese banks when their bubble burst in December of '89. The Japanese central bank handled it as an interest rate and liquidity problem, and they ultimately lowered the interest rate on advances from the central bank down to essentially zero."
In the Japanese crisis of the 1990s, as with the current economic downturn, the root problem was not a matter of liquidity, but of solvency.
"They were pouring money into the system, and what that was doing was prolonging over what was ultimately eight years, the recognition of losses by the Japanese banks," Scott said. "They were kept afloat, but they were not facing up to the losses that they had taken, and that continued to act as a real impediment to the revival of the economy."
Even champions of the Fed's recent actions like Wachovia economist Sam Bullard acknowledge that improved liquidity cannot turn the souring debt underlying mortgage-backed securities into strong investments.
"The Fed is definitely showing its creativity with all the different measures that it has taken," Bullard told SNL. "It realizes that cheap money alone is not going to get us out of this mess." If the Fed can prevent the complete failure of major financial institutions and keep markets from crashing long enough for other regulatory measures to take effect, Bullard claimed, other economic variables like consumer spending could help move the economy out of its current slump. Efforts by other arms of the government to give the economy a jumpstart, including the tax breaks prominent in the economic stimulus package, have yet to take effect. As a result, the market rally that followed the Fed's announcement is not likely to last.
"Everybody's waiting to see if we start to see a pickup in consumer spending at the end of the second quarter, once taxpayers get the checks," Bullard said. "I think we're going to see a lot of choppiness in the markets until then."
But a consumer spending boost would not address bad mortgage debt. "Everybody knows that, in effect, there are a lot of unexploded mines out there," Scott said. "There are losses that haven't yet been taken and haven't been put on the books."
The Fed's authority to defuse those mines is limited.
Bullard praised the Fed for facing up to market realities rather than relying on conservative laissez-faire orthodoxy in orchestrating the takeover of Bear Stearns.
"They tried to draw a line in the sand with Bear Stearns that they're going to do their best to make sure that no other major brokerage houses or banks go under," Bullard said. "If another one were to potentially fail here, I think it could be a big downward spiral spin. I think it could really hit the markets hard."
Although the Bear Stearns rescue reveals that the Fed does not hold any principled opposition to an economic bailout, the regulator's authority to actually implement a full-scale bailout of the financial system could be remote.
"They're not supposed to federalize losses, that's not the job of the central bank," Scott said. "That's a fiscal decision that it seems to me is for the government, the Congress to make. It's not really the responsibility of the Fed, and they don't really have the necessary authorizations and tools to deal with it."
Congress is typically much slower to act than the Fed, and convincing conservative Republicans to endorse a bailout — a necessary task in the sharply divided Senate — could prove difficult, even if some industry observers believe it could be an economically prudent decision.
State Street's Chief Economist Christopher Probyn has noted that the government could establish a floor for the value of troubled securities by purchasing them at a haircut. If liquidity measures prove insufficient, a bailout remains the only other potentially viable course of government action.
"Somebody, and ultimately it will be the taxpayer, begins to say, 'Okay, we stand ready to purchase impaired securities. We won't buy them at par, we'll buy them at a haircut, but we will buy these impaired securities from you,'" Probyn told SNL. "If things get bad enough, there will be some kind of agreement to purchase a certain set of securities at a certain price, so everybody can get them off their balance sheets."
Bullard argues that it is premature to be considering a bailout. But regardless of whether the government comes to the rescue or lets companies take losses on their own, the market turmoil will likely continue until investors know the size and scope of the losses that major financial institutions will have to take from mortgage-related investments.
"One of the problems is, nobody quite knows what the size of the problem is," Probyn said. "The securities are not trading."