Federal Reserve & Interest Rates

The three major investment banks were all downgraded today by Standard & Poor’s and remain with a negative credit outlook as more write downs are expected.  Some experts are predicting over a $1 trillion in write downs for credit markets before it’s all said and done.

Today’s news has probably put an end to the speculation that the Fed will raise interest rates before the fall to combat high energy prices.  The Fed is quickly entering into a no win situation as fears of stagflation begin to take hold of the economy.

When a central bank has an uncomplicated recession to deal with, it can cut interest rates. When it faces a clear-cut case of inflation, it can raise them. The worst nightmare of any central banker – especially one with a tradition of political independence to defend – is stagflation, when raising interest rates to curb inflation will provoke a recession or deepen one that has already begun…

The economy sags under the combined weight of house price falls, consumer confidence at a 25-year low, the credit crunch and a still widening financial sector squeeze. Nonetheless, soaring prices for oil and other commodities, not to mention the higher cost of imports thanks to a devalued dollar, are pushing up inflation and (especially) expectations of inflation.

With the housing slump far from over it is a real possibility that the credit crisis could last well into next year.  As long as home prices keep falling, all mortgage related assets will be at risk from defaults and foreclosures despite the Fed’s attempts to prop up the banking system.

Treasury yields fell to their lowest level since March when investors were coping with the Bear Stearns collapse.  As investors shed risk and take shelter in Treasuries, the flight to quality is also mirrored in the general banking system.

Right now financial institutions don’t trust anyone except the Fed.  They definitely don’t want to lend to each other and only to individuals with the highest credit ratings and because of this mortgage rates are creeping up again.  With the mortgage market in disarray, any possibility of a housing recovery seems farfetched at the moment.

On Tuesday, Fed Chairman Ben Bernanke gave a speech on the role of central banks at a conference at the Federal Reserve Bank of Atlanta.

A sharp housing contraction has generated substantial losses on many mortgage-related assets and a broad-based tightening in credit availability. Consistent with its role as the nation’s central bank, the Federal Reserve has responded not only with an easing of monetary policy but also with a number of steps aimed at reducing funding pressures for depository institutions and primary securities dealers and at improving overall market liquidity and market functioning.

The Fed’s traditional approach to monetary policy was ill equipped to handle the strains the housing contraction caused on the financial system.  It had to initiate a number of new policies to combat the liquidity crisis that many financial institutions were facing.

Besides cutting interest rates to make the cost of credit cheaper, the Fed also reduced the spread to 25 basis points between the federal funds rate, the rate at which banks lend to each other and the discount rate, the rate at which banks borrow from the Fed.  During the current credit crisis banks have been reluctant to lend to each other due to mistrust of their counter parties solvency.

The discount window has also been opened up to non-commercial banking institutions for the first time, providing a credit backstop to investment banks.  They have also had to combat the stigma many financial institutions face that conditions are so bad that they must borrow from the discount window in the first place.

The Fed has had to pump large amounts of monetary funds into the financial system through it’s various auction facilities.  It has also increased the range of collateral it is willing to accept, basically providing a market for mortgage related securities that have grown increasingly illiquid as investor confidence has deteriorated.

While confidence in the credit markets may be slow to return, the Fed has instilled confidence with investors that the central bank will take any step necessary during times of financial stress.