Is Bernanke's Fed Out of Ammo?

With a big interest rate cut expected, the central bank still has a couple of options left.


The New York Stock Exchange: Stocks fell but pulled off their lows as investors digested a plan to alleviate a liquidity crisis at Bear Stearns Cos. that has touched off concerns about the severity of credit troubles.

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Well, the Federal Reserve certainly isn't short on creativity. As the world's financial system slips closer to panic mode, Fed Chairman Ben Bernanke and company have worked feverishly to concoct financial elixirs that are every bit as inventive as the newfangled mortgage products that triggered the current crisis in the first place.

In addition to slashing its benchmark interest rates—the central bank's most traditional monetary policy medicine—the Fed has in recent days arranged a multibillion-dollar emergency loan to a struggling institution, created a new funding channel for large brokerages, lowered the rate at which it offers direct financing to banks, and begun accepting certain mortgage-backed assets as collateral.

"I didn't know they could be as innovative as they have been," says Lyle Gramley, a former Fed governor who now works for Stanford Washington Research Group. "If you had asked me two weeks ago if they were finished [introducing new measures], I would have said, 'Well, I can't think of anything else.' "

The Fed's aggressive actions have come in response to new trouble in the credit markets. On Sunday, federal officials prodded JPMorgan Chase to acquire the once proud Wall Street investment bank Bear Stearns for the "everything must go" price of $2 a share. Last week, Bear suffered a cash crisis as banks and investors—concerned about its exposure to risky, mortgage-backed debt—deserted the 85-year-old company.

The swift downfall of the nation's fifth-largest securities firm—Bear's shares had closed at more than $70 a share just over a week ago—demonstrates the credit crunch's destructive potential and puts new pressure on the Fed to get the markets functioning smoothly again—and fast.

But after having already fired such a barrage at the credit markets, is the Fed out of ammo? Not yet, says Gary Schlossberg, a senior economist at Wells Capital Management in San Francisco. "There are still more bullets," Schlossberg says. "And the bullets, I think, are the federal funds rate, the direct lending facilities, and ultimately...the Treasury."

Bullet No. 1: rate cuts. While the Fed has already slashed the federal funds target rate to 3 percent from 5.25 percent last September, it could certainly reduce the rate even more, starting at its regular meeting tomorrow. Even in the face of record dollar weakness, skyrocketing commodity prices, and troubling data on inflation, the central bank is widely expected to make another aggressive rate cut. "They have to keep lowering interest rates," Gramley says. "I think we'll see probably a [three-quarter-percentage-point] cut tomorrow." Economists at Goldman Sachs expect the Fed to be even more assertive and cut interest rates by a full point. At the same time, the Fed has the option of further lowering the rate at which it lends directly to banks—known as the "discount window." It cut that rate over the weekend by a quarter point to 3.25 percent.

Bullet No. 2: direct lending. In addition to making old-fashioned rate cuts, the Fed has been injecting liquidity directly into the financial system. David Jones, the president and CEO of DMJ Advisors and a former economist at the Federal Reserve Bank of New York, says the Fed could renew or even expand on this initiative. "They're getting liquidity to where it's needed in large amounts in effect through these mechanisms, which can be reused," Jones says. "When you think about it, the crisis of confidence that we've been in and the sudden move from abundant liquidity to scarce liquidity—as poor old Bear Stearns learned—is really the kind of market that needs these channels."

Jones says the Fed would prefer to use targeted lending rather than old-fashioned rate cuts exclusively, since recent cuts have helped spur a decline in the dollar and rising commodity prices.

Bullet No. 3: buying up mortgage-backed assets. Although the Fed is now accepting mortgage-backed assets as collateral, Morris Davis, a former Fed economist who is now a professor at the University of Wisconsin's business school, says the central bank could go a step further and actually buy up some of these risky assets themselves. "If these mortgage-backed securities are the root cause of the financial distress that we are in, then maybe the Fed providing some liquidity to that marketplace is a way to sort of stabilize things right now," Davis says.