Fed Recreates the 1970s; Wait, It's the 1930s: Caroline Baum

Commentary by Caroline Baum

-- The Federal Reserve defied market expectations amid a Category 4 hurricane on Wall Street and widespread flooding on Main Street, holding its benchmark overnight rate at 2 percent.

Whether it turns out to be the right decision in the long run, it was the Fed's, not the market's, to make.

Before the Fed comes under attack -- it's already starting - - for being out of touch and causing Great Depression II, a review of recent history is in order.

It was only three months ago that the collective wisdom of the market anticipated a 75-basis-point increase in the Federal Reserve's benchmark rate by year-end. Inflation was heading higher, policy makers were talking tough, and unless the central bank atoned for the error of its ways and corrected the negative real interest rates, the U.S. was destined to repeat the 1970s.

By early September, expectations for rate increases had evaporated. Stasis, always an uncomfortable place for bond traders, was short-lived. The fed funds futures sashayed in the opposite direction.

As this week got under way, Lehman Brothers Holdings Inc. filed for bankruptcy, Merrill Lynch & Co. leapt into the arms of Bank of America Corp., and American International Group Inc. was scrounging for an emergency loan. The changing financial landscape changed expectations again.

Financial futures contracts were quick to price for a 25- basis-point rate cut at yesterday's meeting. Some economists called for a 50-basis-point reduction in the federal funds rate, which has been at 2 percent since the end of April. A few said the Fed couldn't wait for the meeting and had to cut immediately. The future was looking like 1929, not 1970.

Quantity, Not Price

Yesterday, with stock markets around the world tanking, AIG gasping for air, central banks pouring in liquidity to prevent interbank lending rates from rising further, the Fed demonstrated that it was not in the market-appeasement business.

Why lower the fed funds rate? Banks and a select group of non-banks can borrow at the Fed's come-one-come-all discount window at a cut-rate price of 2.25 percent. The quantity is unlimited. The quality of the securities that the Fed accepts as collateral has gone down. And price isn't the issue.

This is about the availability of credit, or, in this case, the lack thereof. The Fed is trying to address the private sector's tightening of credit with several ``enhancements'' to its alphabet soup of liquidity facilities.

Last weekend, the Fed announced it was expanding the range of collateral it will accept on overnight loans at the Primary Dealer Credit Facility (PDCF) to include equities and non- investment-grade debt, or junk by any other name. Previously, the collateral had to have an investment-grade rating.

More Better

The eligible collateral for the Term Securities Lending Facility (TSLF) was expanded from AAA-rated to investment-grade debt.

The Fed upped both the size and frequency of its TSLF auctions. It pumped a combined $120 billion into the money markets on Monday and Tuesday to address the spike in the interbank lending rates.

A reduction in the federal funds rate isn't going to convince stock market investors that financial companies have properly accounted for their losses. (It wouldn't have the impact, say, of the prospect of a Fed loan package for AIG.) It isn't going to help reduce inflation, which is running well above the Fed's comfort zone and still a concern to policy makers, according to the statement released at the conclusion of yesterday's meeting.

And it isn't going to boost the U.S. dollar, which has been rallying for two months.

Yield Curve Relief

The one thing it will do is ``steepen the yield curve,'' says Paul Kasriel, chief economist at the Northern Trust Co. in Chicago.

Before the Fed announcement, the two-year Treasury note was trading at 1.7 percent. With the funds rate at 2 percent, ``it's hard to make a profit no matter how much volume you do,'' Kasriel says.

And who knows? The drop in two-year note yields might have matched any cut in the funds rate, keeping that spread constant.

The good news is that intermediate and long-term Treasuries offer a positive spread over the funds rate. By borrowing from the Fed and buying risk-free Treasuries, banks ``can earn the spread, improve their profits and build capital,'' Kasriel says. Treasuries aren't subject to the same risk-based capital requirements as private securities.

The positively sloped yield curve provided a way out of the 1990s savings and loan crisis. And it will do the same this time around, too -- slow, arduous process that it is.