All things considered, U.S. central bank chief Ben S. Bernanke and the Federal Reserve have so far demonstrated a tremendous amount of restraint amid the credit crunch.
Market volatility, tightening credit conditions, and the collapse of the subprime-mortgage-stuffed Bear Stearns Cos. (NYSE: BSC) hedge funds – as well as several mortgage lenders operating at the highest end of the risk spectrum – have left many investors nervous. Still, the Fed’s hand remains steady.
On Aug. 7, when Fed policymakers last met, the central bank stood at the precipice of the most disturbing market trouble this year. At the time, it was obvious that a market downturn was looming, and that the subprime mortgage crisis was puffing smoke like a long-dormant volcano that was ready to blow. Curious observers began to speculate that the Fed would take action, cut rates, and preempt what could only become an uglier situation.
But the Fed did nothing.
It acknowledged that the U.S. stock market was volatile, that the U.S. housing market was in peril, and that lending conditions were less than ideal. But it was just as clear that inflation remained the central bank’s main concern. When the two Bear Stearns funds collapsed, and one of the largest banks in Europe –BNP Paribas SA (EPA: BNP) – was forced to freeze a couple of money-market funds that were also loaded with asset-backed commercial paper containing subprime exposure, it was the European Central Bank that took action first.
The ECB was forced to inject a record $130.6 billion in added temporary liquidity into the banking system. The Fed injected another $24 billion dollars. By the end of the week the ECB had issued $214.2 billion, while the Fed had supplied $59 billion to its banks. Last week, Fed Chairman Bernanke announced the reduction of the bank’s discount rate, but held its benchmark Federal Funds rate steady at 5.25%. The Fed Funds target rate is what Fed system banks charge one another for overnight loans.
With their coordinated approach, the ECB and the Fed seemed to add enough liquidity to keep their respective banking systems operating at a reasonably normal level – without having to cut their target rates. In the Fed’s case, that action would run the risk of placing too much liquidity into the financial system. That, in turn, could over-stimulate the U.S. economy, and its banking system – and which would also let the subprime speculators off the hook, since many would be able to refinance, and avoid bankruptcy.
If you think back to 1998, the crisis of the day was the implosion of the Long-Term Capital Management hedge fund. After Russia defaulted on its domestic GKOs, an overleveraged LTCM, and a number of other speculators were forced to purge large portions of their assets. The result was a mad dash to the exits.
The Fed made its move, cutting interest rates twice successively and fixing the problem in that one swoop. Sure enough, however, the law of unintended consequences came into play. The U.S. economy grew at an 8% clip in the last quarter of 2000, driving runaway investments in overvalued tech stocks, and also fueling a corporate and consumer credit binge that led to the 2002-2003 downturn.
The Fed may have learned its lesson. Now it seems reluctant to overreact and potentially create another bubble – and won’t easily opt to “bail out” reckless speculators, blind-to-risk borrowers, and super-aggressive lenders. Instead, the Fed has taken adequate measures to ensure market liquidity, and it has attempted to redress the negative impacts of a global credit crunch.
In short, it is not the central bank’s job to rescue banks or bail out investors who made ill-advised choices. Instead, it’s chief mandate is to, first, battle inflation wherever and whenever it appears; and, second, to remain vigilant against major drop-offs in economic growth.