Fed’s efforts to calm markets are far from over

Fed’s efforts to calm markets are far from over
By Krishna Guha in Washington
Copyright The Financial Times Limited 2007
Published: August 13 2007 19:44 | Last updated: August 13 2007 19:44


The bright start to trading on Monday will encourage Federal Reserve policymakers to believe they have struck the right balance in response to credit market turmoil: stepping up liquidity support aggressively when the interbank market came under strain at the end of last week, but offering no signal that they are yet resolved it will be necessary to cut interest rates.

But the game is far from over, and there is every possibility that – with further credit bombshells likely to shake markets – the coming days will test the US central bank’s resolve and renew pressure for an easing of monetary policy.

The futures market was on Monday pricing in a significant possibility of an emergency rate cut before the September meeting, a full rate cut at that meeting and two more by August of 2008.

“The markets are certainly pricing in aggressive easing, but the Fed is not outsourcing policy to the markets,” says Larry Meyer, a former Fed governor and chairman of Macroeconomic Advisers.

He says the Fed’s “first line of defence” is liquidity support – and that appears to be succeeding in calming markets for now.

Analytically there is a big difference between the Fed providing injections of cash to support its desired policy rate of 5.25 per cent and cutting that policy rate.

Cutting interest rates would certainly boost markets, but the Fed is not aiming to boost markets, or even stabilise markets at current prices.

What the Fed is trying to do is to provide enough liquidity to allow the market to operate as smoothly as possible while it undertakes the painful process of repricing risk and discovering where the losses from subprime mortgages lie.

The Fed wants to help this process along by ensuring it is never compounded by fears about creditworthy institutions’ ability to access short-term funds.

But it cannot directly address the underlying problems – for instance, by revealing where credit losses lie or validating valuation models used to price complex structured credit products.

Policymakers tend to the view that these will simply take time to resolve by market participants.

Interest rate policy will remain guided by the outlook for the economy and the objective of achieving full employment and price stability in keeping with the dual mandate.

The US central bank will only change rates in response to market developments in so far as they alter its economic forecasts or the risks to those forecasts.

The Fed views these recent developments on three levels. First, it sees a significant liquidity problem – which came to the fore late last week. It ramped up the injection of cash into the short-term money markets on Friday after seeing evidence that creditworthy borrowers were struggling to obtain liquidity from their regular counterparties.

In doing so it was performing the classic lender of last resort function – providing liquidity against fundamentally sound collateral.

Second, it sees a big increase in risk awareness. Policymakers view the repricing of risk – which had been very cheaply priced – mainly as a healthy development.

However, they are concerned about the possibility of a buyers’ strike in which investors stop bidding for complex and opaque credit products that they cannot value.

The third level is the macroeconomy. The Fed would obviously respond if a tightening of financial conditions fed through into incoming economic data on spending, growth and prices.

Now it finds itself in a grey area, trying to assess whether changes in financial conditions are enough to alter forecasts and change rate policy.

It appears most policymakers have not yet seen enough evidence to reach this conclusion. But all are watching to see how the market adjustment plays out.

What matters is how deep the pull-back in the credit markets is, and how protracted it proves to be.

The Fed’s hunch is that the hiatus might prove short-lived, and markets will resume more normal operations reasonably soon.

It does not matter much for the macroeconomy if the market for “jumbo” (big loan) mortgage-backed securities closes for a few days and then reopens.

But if the market for these securities remains closed for long, the risk to demand in the economy mounts.

Moreover, continued turmoil in the credit markets could have disinflationary implications.

So while the Fed is by no means yet resolved to cut rates in September, it is possible events could unfold in ways that deliver that outcome.

Mr Meyer says: “I do not think we will get an inter-meeting move, and there is a lot of time between now and September.”