Fed's Bag of Tricks

by John M. Curtis
(310) 204-8700

Copyright October 7, 2008
All Rights Reserved.                    

            Federal Reserve Board Chairman Ben S. Bernanke can’t utter a word without the market taking a nosedive.  With the economy on such shaky ground, Bernanke must choose his words wisely or face panic on Wall Street, where the nation’s biggest funds continue to sell-off equities, taking the Dow Jones Industrials down over 30% from its record high of 14,164 hit Oct. 9, 2007.  Since then, the market has been in steady retreat, cascading 508 points Oct. 7 to 9,477.  Despite the record $700 billion bailout passed Oct. 3, the market continued its downward spiral, following the same path taken after Sept. 11, when markets dropped from around 11,000 to 7,700 in early 2003.  What’s scary is the pace of the today’s decline.  Back in 2001, it took over two years to hit bottom, before the market capitulated and eventually rebounded.  Whether that happens again is anyone’s guess.

            Bernanke and the Fed have been at the center of the economic crisis, doing his utmost to inject liquidity in the system to avoid recession.  Despite tripling banking reserves $900 billion, most financial institutions are pressuring Bernanke to lower the federal funds rate, currently at 2%.  Whether the economy meets the technical definition of recession or not, most economist believe growth has stopped.  “Overall, the combination of incoming data and recent financial developments suggest that the outlook for economic growth has worsened and that the downside risks to growth have increased,” said Bernanke, conceding recession.  Bank of America, formerly the nation’s largest bank, just reported a 68% drop in Q-3 profits, accelerating today’s sell-off.  Financial institutions are looking to Fed to drop its key rate to one percent, almost handing out money free.

            Bernanke and the Fed’s Open Market Committee must decide quickly whether to take down its key interest rate.  Whatever direction the stock market takes shouldn’t influence Bernanke’s decision, since the market has a mind of its own.  Financial institutions must be induced to lend money to stimulate the economy.  Sitting on billions does little to encourage the kind of business and consumer activity needed to turn things around.  When Bernanke slashes rates, most commercial banks follow suit, taking the prime rate down.  A one percent federal funds rate would translate into a 4% prime, encouraging a wide range of consumer debt products.  “In light of these developments, the Federal Reserve will need to consider whether the current stance of policy remains appropriate,” said Bernanke, signaling he might lower rates before the Oct. 28 FOMC meeting.

              Wall Street has a way of correcting itself, ending the current bear market that causes the current sell-off.  Most experts believe stocks remain inflated, requiring a greater correction.  Fund-traders don’t like to pay inflated prices, especially when they see room for more profit-taking.  Today’s continued sell-off should continue to the point of  “capitulation,” when most sellers throw in the towel.  While bears dominate today, the bulls could come back soon when they perceive the market’s next upturn.  “The heightened financial turmoil that we have experience o late may well lengthen the period of weak economic performance,” signaling his intent to cut the federal funds rate.  Adding more to banking reserves and cutting the federal funds rate will eventually induce banks to begin aggressive lending practices.  Money on the shelf does little to augment the bottom line of commercial banks.

            Selling-off stocks has little to do with the current liquidity problem in financial markets.  Bernanke and Treasury Secretary Hank Paulson have taken decisive steps in short-order to resolve today’s cash crunch, causing banks to sit on their capital.  Berananke will goose the system along by lowering the federal funds rate, in effect, giving banks free money to augment profit margins on the commercial market.  When banking reserves and bailout kicks in, commercial banks will stop sitting on their hands and start lending-out money.  Consumers will start borrowing and spending when banks, like gas stations, make consumers offers they can’t refuse.  No one expected Wall Street to stop selling off from the bailout or the Fed’s move to add $600 billion to banking reserves.

            Signaling lower interest rates, Bernanke has left little doubt the Fed means business about inducing commercial banks and start lending money.  Cutting interest rates will give banks more incentive to lend out money, improving today’s cash-crunch.  “These are momentous steps, but the are being taken to address problems of historic dimensions,” said Bernanke, reminding the market that the Fed is poised, together with the Treasury Dept., to do whatever it takes to restore financial markets.  No one knows for sure when growth will return to the economy.  What is known is that the Fed’s macroeconomic policy will eventually cause more lending and consumer spending, accounting for more than two-thirds of the nation’s Gross Domestic Product.  Prophets of doom-and-gloom beware:  The Fed has acted, markets will respond and the economy will eventually turn the corner. 

  John M. Curtis writes politically neutral commentary analyxing spin in national and global news.  He's editor of OnlineColumnist.com and author of Dodging The Bullet and Operation Charisma.

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