Yesterday the Fed cut US interest rates by 0.75%,on top of the 2.25%of cuts since last summer and hot on the heels of last week’s measures to stimulate liquidity and address funding problems through a new USD 200 billion lending facility for the banking system.
These measures have been particularly aimed at helping the increasingly distressed mortgage market. But despite the Fed’s efforts, credit markets remain blocked and investors are still looking for an answer to the ongoing and seemingly unquenchable market volatility.
However, perhaps investors and the Fed alike have been seeking the answer to the wrong, or at least different, questions.
Let’s look first at the average investor “on the street”. They cannot help but feel bombarded at the moment by a constant flow of bad news regarding the economy (the majority of financial analysts and journalists are now apparently in agreement that the US economy is actually in recession), and regarding the subprime crisis, where rumours andannouncements of financial company writedowns continue to undermine confidence.
Perhaps then the Fed’s willingness to act, while warmly receivedat first, is on reflection being perceived as confirmation of the darkest rumours and predictionsabout the US housing and mortgage markets currently doing the rounds. Why else would the Fed so deliberately seek to promote the orderly functioning of the mortgage market?
This theory could be borne out by the reaction of equity markets(and the USD) to the Fed’s creative actions over the last few months, with the S&P 500 downmore than 10% since the beginning of the year. Part of the problem is that the Fed, unlike the ECB and Bank of England, has the dual responsibility of promoting macroeconomic and financial stability. To this end the Fed has aggressively hacked interest rates, but so far this has not produced the desired effects of lower interbank lending rates or improved liquidity.
For the average home owning American, the Fed’s policies aren’t working because banks are not passing low Fed funds rates on in the form of lower mortgagerates. Instead they are keeping the increased spread for themselves in a bid to shore upcash reserves, and particularly in the US and the UK this is having a real impact on the finances of ordinary investors.
The ineffectiveness of monetary policy, at least on its own, to bring stability to the credit markets has led the Fed to be increasingly creative in its use of other measures, such as last week’s USD 200 billion coordinated effort with other central banks to improve liquidity. However, each successive measure has produced little other than short-term relief for investors.
Perhaps, then, in targeting liquidity, the Fed is trying to answer the wrong question. Instead, perhaps the real problem is now one of solvency, rather than liquidity.
If so, then some commentators are now suggesting the Fed should go one step further than its current measures that will already take up to USD 400 billion of mortgage assets onto its balance sheet, and provide real support for asset values throughthe outright purchase of non-government securities. But any outright purchase of US mortgageswould be a very difficult and messy business –for example, how much should the Fed pay, and which mortgages would qualify? It would be a very brave step indeed.