No Rate Cut by a Confident Fed

Too confident, perhaps.

Federal Reserve Law Enforcement officers stand outside the Federal Reserve September 16, 2008 in Washington, D.C.

The Federal Reserve.

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In the end, interest rates are almost beside the point. The real story in the Federal Reserve's no-rate-cut announcement is its only passing mention of the current financial calamity.Ben Bernanke and the Fed left the benchmark federal funds rate unchanged at 2 percent. The policymakers acknowledged financial market strains have "increased significantly" and warned of slower growth caused by credit and housing problems, but they veered away from specific mention of the turmoil caused by this week's bankruptcy of Lehman Bros., the historic $50 billion buyout of Merrill Lynch by Bank of America, and the possible looming failure of insurer American International Group.That's a bit odd, given that central bankers have spent most of the past two weeks meeting with bank heads and regulators to decide how to stop the bloodshed in what has become Wall Street's biggest challenge in decades.The Fed made its message clear: It has now halted what was viewed by markets as unqualified support for the U.S. banking system. Allowing Lehman (and, though possibly not, AIG) to fail, telegraphs that the Fed is confident in its ability to steer financials toward safer waters.The statement is also a nod to the tricky balance between managing slowing U.S. growth and rising inflation pressures. While inflation has cooled recently, with prices for energy and commodities falling notably in the past two months, upward pressures remain. Oil may be below $100, but that doesn't negate the impact of high prices at the pump all summer long. Hopes that inflation will moderate through the end of the year remain just that for the Fed, who calls the current outlook "highly uncertain." That means a rate cut in October is not a sure thing.Economist reactions were muted:
I believe the Fed made the right call on the rate decision but it is hard to take much comfort from a policy statement that seems so oblivious to recent developments. In any case, the Fed's decision can be interpreted as an implicit statement of confidence that it has the tools in place to ensure the liquidity of the financial system. By leaving the funds rate unchanged, the Committee also has kept some of its powder dry and ready for use if conditions deteriorate further. The considerable risk that more powder may yet be needed seems to justify this conservative approach.
—David Resler, Nomura SecuritiesThe Fed left rates on hold, and to read their statement, you would never know the sky has fallen in on Wall Street. No mention of the chaos beyond "Strains in financial markets have increased significantly". Gold medal for understatement.
—High Frequency EconomicsThe statement announcing this decision—while expressing more concern about the growth outlook—did not show quite the urgency we anticipated. In particular, commentary about inflation did not change, and the committee's assessment of growth and inflation risks was essentially balanced, as opposed to signaling a greater concern about growth.
—Goldman SachsPost-statement armchair psychology surrounding the Fed's decision to leave rates alone goes like this: A big rate cut or direct reference to severe economic or financial weakness would spook markets, so policymakers kept the statement fairly balanced. Instead, central banks will continue to rely heavily on other sorts of funding to assuage nervous lenders.Interest rate moves may be the biggest club for muscling markets, but Bernanke is using other methods more heavily than ever. The Fed injected $70 billion into the system in the form of temporary reserves today, matching yesterday's total. It will also continue to accept a wider range of collateral from borrowers, including equities. Other banks are following suit. This week, the European Central Bank injected $100 billion, and the Bank of England offered up more than $40 billion in short-term funding.The Fed knows it's playing a dangerous game. If markets start to believe that the government backstop has been removed, expect financial sector problems to emerge at a more scorching pace among banks most exposed to the weakest parts of the market and at companies in desperate need of fresh capital. Consolidation that began with the $50 billion emergency buyout of Merrill Lynch by Bank of America may just be getting started.


TAGS:
economy
stock market
Lehman Brothers
AIG, Inc.
inflation
Bernanke, Ben
Federal Reserve
interest rates
  • Kirk Shinkle

    Kirk Shinkle is a senior editor for U.S. News Money and manages the Best Funds portal. Follow him on Twitter @KirkS or email him at kshinkle@usnews.com.