By Jennifer Yousfi
Citing balanced threats from weak economic growth and inflation, the U.S. Federal Reserve yesterday (Tuesday) voted to hold the benchmark Federal Funds rate at 2.0%, despite a financial market that has been rocked in recent days by the continued fallout of the credit crisis.
“Downside risks to growth and the upside risk to inflation are both of significant concern,” the policymaking Federal Open Market Committee (FOMC) said in its statement yesterday. “The committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.”
The FOMC statement openly acknowledged the many downside risks to domestic economic growth.
“Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters,” the FOMC policymakers said. “Over time, the substantial easing of monetary policy combined with ongoing measures to foster market liquidity should help to promote moderate economic growth.”
The monetary policy committee, headed by Federal Reserve Chairman Ben S. Bernanke, stood firm on the threat of inflation, as well.
“The committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain,” the Fed said.
“Did the Fed do the right thing? We will know the answer to that only in time, but it was a reasonable decision,” Joel Naroff, president and chief economist of Naroff Economic Advisors, said in a research note after the decision.
“As I have noted on a number of occasions, the problem is not the level of rates but liquidity and the willingness to lend,” Naroff added. “If the Fed had cut the [Fed] Funds rate, it would have lowered costs to financial institutions, but not caused them to lend a whole lot more.”
In the current environment, financial firms are hoarding cash to bolster capital positions, lest they become the next to suffer a crisis of confidence. At the same time, most remain extremely risk averse when it comes to lending.
Reaction to the FOMC decision was mixed. Many analysts felt that a rate cut would have gone a long way to soothe the panicked financial sector. Just prior to the Lehman Brothers Holdings Inc. (LEH) bankruptcy filing, it had been widely anticipated that the FOMC would vote to hold its key interest rate steady at 2.0% when it met yesterday.
With the collapse of Lehman Brothers, Fed Funds futures traded on the Chicago Board of Trade had priced in an almost 72% chance of a quarter-point reduction in the benchmark Federal Funds rate prior to the meeting, indicating that investors had high hopes for a cut.
Even analysts who had expected the Fed to hold the line on interest rates were surprised that the statement didn’t strike a more dovish tone.
“We didn't expect a cut from them but to be honest I'm a little surprised that the statement isn't a little more dovish,” Carl Lantz, U.S. Interest Rate Strategist at the Credit Suisse Group AG (ADR: CS) in New York, told Reuters. “They didn't give a whole lot of ground.”
“They are still expressing concern for inflation, which I think at this point is a little bit like yesterday's news,” Lantz added. “With emerging economies slowing down, that pressure on input costs is definitely coming off and with the banking sector under so much stress you have actually a deflationary shock domestically.”
Others felt the Fed’s emergency liquidity measures were enough at this time and a rate cut wasn’t needed.
“The bottom line is watch what they do, not what they say,” James Caron, co-head of Global Rates Research at Morgan Stanley (MS), told Reuters. “They pumped the market up with a $140 billion liquidity injection (through overnight repos on Monday and Tuesday), and if I had to choose between that and a 50-basis-point cut today – which is more symbolic – I'd choose the $140 billion.”
“The Fed is doing what they need to do, they are pumping the market with more liquidity, and that is the right thing," Caron added.
As the news of Lehman’s bankruptcy filing roiled the financial markets, the Federal Reserve announced emergency measures designed to smooth volatility. One such move included an increase to the Fed’s loan program – by widening the types of collateral available for loans.
“The steps we are announcing today, along with significant commitments from the private sector, are intended to mitigate the potential risks and disruptions to markets,” Bernanke, the Fed chief, announced on Monday.
Bernanke outlined a plan designed to pump liquidity into the capital markets after U.S. Interbank lending rates zoomed to 6%, three times the Fed’s 2.0% target. It was the widest margin over the Fed’s target in more than a decade, and stems from the fact that – as the markets grow even more risk-averse – banks are holding onto capital and demanding a premium for lending.
The Fed has also expanded the types of securities that can be pledged for collateral at the Primary Dealer Credit Facility. Previously, the PDCF had been limited to investment-grade securities. Now collateral “has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks,” the Fed's Monday press statement said.
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