The Federal Reserve’s long-held and much-repeated supposition that problems in the sub prime mortgage market would remain contained and not spill over has, of course, proved wrong. And so what once looked like a predictable, even boring year for monetary policy became all-too interesting in a big hurry in August.
Fed policy, in fact, had to do a “180” as the subprime conflagration — a “bonfire of the vanities” for our vauntedly “sophisticated” investment institutions and markets — spread throughout the financial system and threatened to undermine the economy.
While the Fed had long acknowledged that the housing correction could prove worse than expected, it failed to foresee how mounting mortgage delinquencies and foreclosures would trigger a panicky chain reaction of distrust among counterparties in global credit markets.
Regardless of whether former Fed Chairman Alan Greenspan caused the subprime mortgage mess, as some have alleged, by holding the federal funds rate too low, too long and by failing to crack down on abusive lending practices, his successor Ben Bernanke has to deal with the aftermath. And he’s handled the challenge calmly and responsibly.
The Fed demonstrated its flexibility in fulfilling its lender-of-last-resort role.
At its Aug. 7 meeting, the Fed’s policy-making Federal Open Market Committee (FOMC) kept policy on hold and reiterated that its “predominant policy concern remains the risk that inflation will fail to moderate as expected.”
Ten days later, the Fed slashed its discount rate by 50 basis points, lengthened lending terms and expanded the collateral it would accept, all while aggressively using open market operations to inject reserves into the banking system.
On Sept. 18, to the delight of Wall Street, the FOMC slashed the federal funds rate a greater than expected 50 basis points and cut the discount rate again by a like amount.
Progress in bringing down core inflation gave the Fed the credibility, and hence leeway, to lean against the credit market headwinds. But the Fed was not throwing caution to the wind.
Significantly, in cutting the funds rate by 50 basis points, the FOMC did not tilt clearly toward further rate cuts, even though it had done so in an Aug. 17 special statement by saying “downside risks have increased appreciably.”
The more non committal Sept. 18 rate announcement simply said, “Developments in financial markets since the Committee’s last regular meeting have increased the uncertainty surrounding the economic outlook.
The FOMC will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.”
This is not exactly an overt easing bias. Moreover, the Fed did not further narrow the spread between the discount rate and the funds rate, as many had hoped. That might also have shown a more decisive leaning toward additional easing.
Divergent views expressed by officials leading up to the meeting make it reasonable to infer that a compromise was struck.
Some wanted bold action, but others were unsure how much easing was needed on top of the liquidity steps already taken. The rate announcement suggests consensus was reached to take aggressive action now but to not signal a predisposition to keep easing. The Fed was thus able to present a united front and give quick, substantial relief to adjustable rate mortgage holders without committing to an uncertain series of further cuts.
Bernanke’s Congressional testimony two days after the FOMC decision was also revealing. Legislators wanted to know why the Fed had cut by 50 instead of 25.
Bernanke explained that “over the month of August the financial market turmoil has effectively tightened credit conditions,” and said, “that has the risk of making the housing correction more severe and it may have other effects on the economy... so we took that action to try to get out ahead of the situation, try to forestall potential effects of tighter credit conditions on the broader economy.”
One interpretation of this desire to get out ahead is that policymakers hoped, by doing more than anticipated, they might have to do less later. They telescoped the amount of needed easing into the present. It would be hasty to infer that the FOMC thereby enabled itself to stay on hold or even that it lessened the cumulative amount of easing required. But the FOMC’s preemptive approach suggests Bernanke and company would like to get their easing job done as soon as possible.
As well they might. The longer the Fed is drawn into a drip-drip-drip process of incremental easing, the more it might extend economic and financial uncertainty, not to mention untoward speculation about dollar depreciation and inflation.
Steve Beckner is senior correspondent for Market News International, which sponsors his Web site “The Beckner Report.” He is regularly heard on National Public Radio and is the author of Back From the Brink: The Greenspan Years (Wiley).