After 18 months of inertia, Fed Chairman Ben Bernanke has finally done something: succumb to pressure from Wall Street. On August 17, the Fed cut the discount rate 50 basis points (b.p.), to 5.75%, in the first inter-meeting move since 9/11, after the $33 billion excess it pumped into the credit system over the previous week failed to calm the markets. Both European and U.S. stocks rallied on the news, and intermediate Treasuries followed suit.
At least one primary dealer is now forecasting 50 basis points worth of cuts in the fed funds target by yearend, and the December funds futures contract yield suggests traders think the Fed will move even more. The downward movement in the two-year yield also suggests that intermediate traders anticipate an imminent ease. Bernanke had been trying to avoid the so-called “Greenspan put,” but ultimately he caved to pressure from investment banks around the globe. Stock traders are happy, and Jim Cramer–whose rant exhorting Bernanke to open the discount window became the most-viewed video on Youtube–is ecstatic.
But will it be enough? The open-market operations executed over the week before the cut were at first welcomed, but they didn’t do enough to calm the markets. As the news hit that Countrywide Financial had tapped its $11.5 billion line of credit, and that Merrill Lynch had rated its stock a “sell,” citing the risk of bankruptcy, the markets continued to panic–and clamored for a bailout from the Fed.
With the next wave of bad news from a big hedge fund, a Countrywide, or housing data, the pressure will be back on “Helicopter Ben” to change monetary policy and cut the funds target, ignoring the inflation pressures that he said remained the primary concern earlier this month. Crude oil jumped on the Fed’s action August 17, which only adds to those concerns, as softer oil prices have been a major contributor to easing price pressures over the last four months.
Maintaining An Even Pitch
The Fed’s move was a knee-jerk reaction, painting Chairman and his colleagues as vulnerable to pressure from big finance. I’ve been saying all year that the subprime debacle would have far-reaching economic implications; yet every bit of positive news in the housing data was viewed by the consensus as a “turnaround,” in spite of the clarity of the trends.
Case in point: Overly optimistic builders broke ground on more houses than economists expected this past March, leading some economists to proclaim that the worst for the housing sector was behind us. But, besides the builders’ optimism, March also saw unseasonably warm weather, which essentially just shifted some starts from April into March. A similar pickup in manufacturing in the second quarter, which was largely just a rebuilding of inventories following the paring that took place over the prior two quarters, was heralded as a rebound in the factory sector. Now, the pundits are acknowledging that final demand won’t salvage manufacturing through the remainder of this year.
One can hardly blame these economists for their optimism–after all, the bulk of them work for money-center banks and Wall Street firms, who profit from a rosy outlook. It behooves their employers to have borrowers keep borrowing and investors keep investing, especially in a securitized world where deal flow trumps credit quality, as the toxic waste can simply be packaged and repackaged, then sold off to hedge funds or used to fund speculative LBOs by private equity firms. Thus, hope springs eternal on the Street.
But the rose-colored glasses set has been proved wrong time and again, and now the birds have come home to roost, damaging Wall Street’s ability to keep funding the deal-flow machine. Never mind that the implications on the broader economy have yet to be felt (as we still contend they will); in a year when the stock market’s rally has been driven by speculative LBOs, which have been funded by cheap loans collateralized with subprime-backed debt, any constraint on the ability to keep feeding the monster naturally puts the Street in full-panic mode. In turn, this is exerting considerable demands on a Fed Chairman who has now proven to be as acquiescent to the pressure as his predecessor.
So now what? If the Fed indeed cuts the funds target in the face of Wall Street pressure, it’s 1998 all over again, and we’ll be fueling yet another asset bubble (equities), even as one is still in the process of slowly deflating (housing). The cut in the discount rate is unlikely to help the latter asset class, as the 10 b.p. jump in the 10-year yield in reaction to the cut will keep mortgage rates from softening enough to stimulate demand (fixed-rate mortgages are priced off the 10-year Treasury). And while lower short-term rates might help ARM borrowers, tighter credit standards mean fewer lenders willing to underwrite ARMs to borrowers who only qualify based on the teaser rate.
Some economists–most of whom are employed by the big banks and Wall Street firms that benefited most from the cash infusion and discount-rate cut–applauded the moves, noting that the Fed was appropriately fulfilling its role as lender of last resort. That’s fine, as long as that’s as far as they go. But now that Wall Street has seen Bernanke acquiesce to its panicked demands, it”s as likely to push him further as a petulant child who’s seen his mother cave in to his whining.
Hopefully, Bernanke will prove his critics wrong, and demonstrate that he understands that the purpose of monetary policy is to strike a balance between output growth at its potential and controlling inflation–not a tool to shore up markets. If he refrains from cutting the funds target, he’ll have accomplished that. If he caves to the renewed pressure, which undoubtedly will come, “Helicopter Ben” will draw unfavorable comparisons to his predecessor, “Bubble Man Greenspan.”