Unsettling Truths

Recent developments have brought home a number of unsettling truths about the Federal Reserve, including the role it played in bringing about the current crisis and the fact that it is unable to perform what most people believe is its primary function: ensuring the stability of the U.S. financial system.

Under the circumstances, how long will it be before reports like the following from Bloomberg's Rich Miller, "Bernanke Plays 'Whac-A-Mole' With Turmoil in Markets," leave many Americans wondering why we have a central bank at all?

Federal Reserve Chairman Ben S. Bernanke may be facing something worse than a loss of personal credibility on Wall Street and in Washington: waning faith in the ability of the institution he leads to turn around the economy and the financial markets anytime soon.

Bernanke has reached deep into the Fed's toolkit to come up with innovative ways to head off a recession and restore some calm in credit markets. While many have initially been greeted with rallies in stocks, cumulatively they haven't yet had lasting impact on bringing down credit costs and setting the stage for economic recovery.

"The Fed has been playing the equivalent of Whac-A-Mole as financial turmoil keeps cropping up in new and unexpected places,'' says former Fed Vice Chairman Alan Blinder, referring to the arcade game where players try to hammer down plastic critters that randomly pop out of holes. ``Yet many of the problems facing us are beyond its reach."

Home buyers are unlikely to put down offers on houses that they think will lose value -- no matter how much the Fed does to lower mortgage costs. Banks with mounting loan losses will shy away from lending to borrowers they think might go bust -- no matter how much money the Fed pumps into the financial system. And investors will remain jittery -- even after the Fed throws a lifeline to struggling financial institutions, as it did last week with Bear Stearns Cos.

Pressure Building

"The Fed is attempting to catch some of the spillover and plug some of the holes in the system," says Louis Crandall, chief economist at Jersey City, New Jersey-based Wrightson ICAP LLP, a unit of ICAP Plc, the world's largest broker for banks and other financial institutions. "But the amount of pressure in the system is still building and could exceed the Fed's traditional resources."

Yesterday the Fed said it would provide financing for JPMorgan Chase & Co.'s purchase of Bear Stearns Cos. for as much as $270 million after a run on the company ended 85 years of independence for Wall Street's fifth-largest securities firm. The Fed also reduced the rate on direct loans to commercial banks by a quarter percentage point and said it will allow primary dealers to borrow at the rate in exchange for a ``broad range'' of investment-grade collateral. It extended the maximum term of discount-window loans to 90 days from 30 days.

Stocks, Dollar Tumble

Even so, Japanese stocks tumbled, with the Nikkei 225 Stock Average dropping 3.7 percent at the close in Tokyo.

"The moves seem to have little effect mainly because of weak confidence," says Charles Chen, who helps manage $3.7 billion at JF Asset Management Co. in Taipei. ``Investors simply are unwilling to take risks despite share prices being cheap. Cash is king now, and investors will continue to reduce their stock holdings.''

The dollar fell below 97 yen for the first time in 12 years and reached record lows against the euro and the Swiss franc.

Financial markets are in "uncharted waters," former U.S. Treasury Secretary Robert Rubin said in a March 14 speech in Washington. "The outlook for credit markets and the economy is uncertain'' and the government may need to take "substantial additional action" to help homeowners, said Rubin, now chairman of Citigroup Inc.'s executive committee.

Fed officials insist they aren't impotent and say they have moved to cushion a further weakening of the economy. They argue the economy and the markets would be worse off if the central bank hadn't cut interest rates and acted to relieve strains in the financial system.

FOMC Meets Tomorrow

Futures traders are betting that Bernanke and his colleagues will lower the target overnight rate by at least 0.75 percentage point when they meet tomorrow, bringing the cumulative reduction since September to 3 percentage points. That's a quarter point more than the cuts his predecessor, Alan Greenspan, instituted when faced with a recession in the first half of 2001.

A growing number of Wall Street economists, including Ethan Harris at Lehman Brothers Holdings Inc. and John Ryding at Bear Stearns, say the economy is already in a recession. Most are betting that rate cuts and tax rebates will keep the decline from being much worse than in 2001, when the economy shrank 0.4 percent peak to trough.

The risk is that the recession feeds on itself and gets much worse. Jan Hatzius, chief U.S. economist at Goldman Sachs Group in New York, sees a 30 percent chance that the decline turns out to be deeper than in 1990-91, when the economy contracted by 1.3 percent.

Rogoff's Scenario

"The best-case scenario is two to three quarters of mild recession followed by a tepid recovery," says Kenneth Rogoff, former chief economist at the International Monetary Fund, who's now at Harvard University.

Former Treasury Secretary Lawrence Summers, also now a Harvard professor, sees a risk of three vicious circles deepening the contraction. The first occurs when cutbacks in consumer spending hit profits at businesses and cause them to trim payrolls, prompting consumers to pull back further.

Sears Holdings Corp., the biggest U.S. department store company, said last month it will fire 200 workers at its Hoffman Estates, Illinois, headquarters.

Summers's other vicious circles relate to credit. As stock and bond prices drop, banks demand more margin from borrowers, prompting them to sell assets to raise cash and driving prices even lower. At least a dozen hedge funds have closed, sold assets or sought fresh capital in the past month.

Asset Prices

Finally, falling asset prices erode borrowers' net worth and make lenders even more reluctant to give them money. Countrywide Financial Corp., the biggest U.S. mortgage lender, made no subprime loans last month, down from $2.6 billion in February 2007.

The housing market so far has proven resistant to the Fed's monetary medicine.

Investors have become gloomier about the outlook for house prices since the start of the year, according to trading in futures based on the 10-city S&P/Case-Shiller price index. Traders see prices tracked by the index falling 13-1/2 percent by November, more than double the drop foreseen in early January.

"It's not showing any signs of letting up," Robert Shiller, one of the creators of the index and chief economist at MacroMarkets LLC, told Bloomberg Television Feb. 27. "If anything, it's accelerating downwards.''

Providing a Bottom

Greenspan said March 5 that home prices need to stop falling to help alleviate the turmoil in financial markets by providing a bottom for the value of mortgage-backed securities. Banks have posted $195 billion of losses since the start of last year, and are getting stingier with their money.

A third of 475 chief financial officers surveyed by Duke University and CFO Magazine through March 7 said their businesses had been directly affected by scarcer credit. Three-quarters said the Fed rate cuts had had no impact.

That has some investors convinced there's only so much the Fed can do. Tom Gallagher, senior managing director at International Strategy & Investment Group in Washington, said investors increasingly believe the federal government will have to buy up mortgages on homes that have lost value to help turn the economy around.

"What is really needed is some help from the fiscal authority targeted at stopping property deflation," says Paul McCulley, a portfolio manager at Newport Beach, California-based Pacific Investment Management Co., which oversees the world's biggest bond fund.

Contrast With 2007

Such sentiments are in contrast to last year, when investors and lawmakers were criticizing Bernanke for being behind the curve, and analysts like McCulley were urging the Fed chairman to cut rates faster.

Lawmakers acknowledge limits to the Fed's ability to aid the economy. Barney Frank, the Massachusetts Democrat who heads the House Financial Services Committee, praises Bernanke as doing a "very good job," while adding there is only so much he can do.

"We have taken fiscal and monetary policy as far as they can go,'' Frank told the American Bankers Association March 12. He unveiled legislation the next day to expand the government's role in helping homeowners avoid losing their houses.

Bernanke himself has tacitly admitted the Fed's leeway is limited by backing the $168 billion stimulus package passed by Congress last month and calling on banks to write down the principal on some of their mortgage loans.

"We must be cautious in our expectations of what monetary policy can accomplish," Kansas City Fed President Thomas Hoenig said in a March 7 speech.

Comments

[bobn]

At this point, talking of the Fed's goal as 'avoiding recession' or 'lowering credit costs' is an error IMHO. I think they're just trying to avoid a depression or total chaos. I don't agree with much of what they're doing - nationalization of the IBs followed by execution of their senior officers and BODs would have been cleaner and have less moral hazard. But the goalposts have changed.

[Retired U.K. fund manager.]

All those foreign holders of dollars are being ignored by the Fed. Their patience must be wearing very thin. Pretty soon such patience may snap and then the Fed may have to RAISE interest rates sharply to protect the currency from a catastrophic collapse.
Other countries have had to do it including my own. I dread to think what might happen in such a case bearing in mind the general indebteness in most corners of U.S. life today.
The Fed is playing with fire.

[Jes]

How many companies can the Fed rescue? Rumors are that Lehmans is next. At what point does the Fed/s blood bank run out and there can be no more transfusions?