With U.S. financial markets under their most severe stress in years, if not decades, the smart money was on the Federal Reserve to cut interest rates on Sept. 16. The smart money was wrong. Defying expectations on Wall Street, Chairman Ben Bernanke and his fellow rate-setters on the Federal Open Market Committee left the federal funds rate unchanged at 2%.
Why? Because the Fed decided that a rate cut was the wrong treatment for the ailing patient. Instead of making loans cheaper, the Fed is focused on the very different task of making loans more widely available. The key problem in the credit crunch, as the Fed sees it, is that lenders are hoarding cash and refusing to lend to one another at any rate. So it's stepping up its own efforts to serve as a lender of last resort, supporting institutions that have trouble getting money anywhere else in the current panic.
In quieter times, economists pay a lot of attention to conventional indicators like unemployment and inflation. But right now, the key indicator for economists inside and outside the Fed is the health of the financial system. Because credit is the lifeblood of the economy, and if it dries up all bets are off.
One measure of how chaotic things have gotten is the huge swings in the rate that banks are actually paying for federal funds, vs. the 2% target that the Fed is aiming for. Federal funds are simply dollars that banks borrow from each other in overnight loans to bolster their reserves at the Fed. On Sept. 15 that rate swung all the way from a low of 0.01% to a high of 7%, according to the Federal Reserve Bank of New York. "The interbank market is dysfunctional right now," says Lou Crandall, chief economist of Wrightson ICAP, the New York research arm of London-based broker ICAP (IAP.L).
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Even though the Fed isn't cutting rates, it's working hard to bring stability to the financial markets. Timothy Geithner, president of the Federal Reserve Bank of New York, has been in daily meetings with leaders of key players, including embattled American International Group (AIG). At the same time, the New York Fed is making lots of loans through its so-called discount window. Also, the Fed injected a bigger-than-usual $70 billion into the banking system on Sept. 15 to satisfy a cash-hoarding surge among banks. It pumped in a further $50 billion the next day. Crandall said the Fed "supplied the banks with more reserves than they will need for weeks to come."
The Federal Open Market Committee chose not to call attention to the Fed's central role in stabilizing the financial markets. Instead, its statement focused on the traditional issues. It acknowledged growing troubles in the financial and labor markets but said: "The downside risks to growth and the upside risks to inflation are both of significant concern."
Wall Street took the Fed's action—or nonaction—in stride, possibly reading its refusal to cut rates as a signal that the financial situation is less dire than feared. The Standard & Poor's 500-stock index fell about 1.5% immediately after the Fed's early-afternoon announcement but then bounced upward. Helping the market in late trading was the prospect that the Fed would lend money to AIG (BusinessWeek.com, 9/16/08). The S&P closed the session with a gain of 1.7%, to 1213.60, up from 1192.70 on Monday.