The Fed's Lifeline

Investor's Business Daily

December 12, 2007

Monetary Policy: The Fed giveth, and the Fed taketh away. That's how markets reacted to central bank moves in the last two days to ease fears that a financial crisis is brewing. Too little? Too late? Stay tuned.

Related Topics: Economy

With investors clamoring for a more aggressive move, financial markets plunged after what was widely regarded as a disappointing rate cut of 25 basis points on Tuesday.

Then, less than 24 hours later, the markets soared on news the Fed would join other major central banks to address the world's dollar-liquidity crisis. Most of the gains evaporated after oil prices surged, but the market's basic message had been delivered:

If the too-small rate cut was a mistake, the Fed's additional move to prevent a global credit crunch, and possibly recession, was not.

Like others, we were flummoxed by the Fed's decision to trim rates only a quarter-point to 4.25%. It was like administering cold medicine to stop an outbreak of the plague.

We also wondered why the Fed waited a day to announce the new lending tool, by which the Fed will inject billions in dollar-based liquidity into global markets. Hopefully it wasn't desperation.

Using its novel "Term Auction Facility" - a fancy name for letting banks bid in the open market for funds instead of having the stigma of borrowing from the central bank's discount window- the Fed will push upward of $40 billion of short-term liquidity into the world financial system and maybe more.

The Fed will also set up lines of credit to let foreign banks borrow dollars when they need them - thus easing their dollar crunch.

This should do two things: (1) make more money available to lend at capital-constrained banks, and (2) lower the cost of funds. And maybe, just maybe, these moves will keep the world from sliding into a recession.

We don't want to get too bullish about the Fed's move. But it beats doing nothing.

The new auction lending system is a creative response to a potential problem. It shows that the Fed's not sitting on its hands. But we still think the Fed should have been more aggressive on the domestic side by cutting the Fed funds rate a full half-point.

Despite inflation fears, many signs of economic weakness that didn't exist a month ago have emerged, thanks in large part to the uncertainty surrounding U.S. financial and housing markets.

Those who still believe there's a serious inflation threat need to understand that most of our recent price pressures come from just one commodity: oil. After a report Wednesday that U.S. crude stockpiles fell unexpectedly, oil leapt $4.37 a barrel to $94.39.

As for those who fear the Fed's actions will only encourage banks to take more bad risks - what economists call "moral hazard" - we ask: What would they have the central bank do? Let dozens of banks fail, taking billions of deposits with them and turning a still-manageable credit crunch into a full-blown financial crisis?

The answer to us is clear, despite any philosophical objections we might have about government meddling in markets.

The Fed's statement justifying the rate cut gave ample clues that even policymakers are worried. It noted signs that housing's woes are starting to hurt business and consumer spending. Worse still, it said financial markets appear to be "deteriorating." Neither is a recipe for future economic success.

Will the Fed's strategy work? Estimates for fourth-quarter GDP are all over the board, with some even expecting a downturn. For next year, the consensus seems to be centered on growth of 2% or so - not great, but no meltdown.

So far this week, the Fed is batting .500 - a great average for a baseball player but a lousy one for a central bank. To show it's really on the ball, the Fed needs to cut rates again - and soon.

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