Fed's Big Dilemma: What If Rate Cuts Don't Work?

As the Federal Reserve tries to head off a recession, it's facing the troubling reality that its primary weapon--interest rate cuts--may not matter anymore.

Despite several rate cuts--including a 1.25 point decline in January alone--the moves have done little more than give the stock market a temporary bounce.

Pablo Martinez Monsivais / ASSOCIATED PRESS Federal Reserve Bank Chairman Ben Bernanke

Meanwhile, recession worries continue to grow--even among Fed officials themselves.

The problem, analysts, say, is that the rate cuts haven't encouraged banks to start lending again. After billions of dollars of losses from subprime debt, banks are still reluctant to put money into the cash-starved economy. As a result, doubts are growing that the Fed can do much of anything to get the economy--and the markets--back on solid footing.

"This particular recession may be somewhat immune to monetary stimulus," says Barry James, president of Cincinnati-based James Advantage Funds. "It's almost like pushing on a string."

Banks are essentially caught in a Catch 22.  They're being encouraged to tighten lending standards because of the subprime collapse, but those stricter policies are countering the effects of the Fed's aggressive rate cuts.

Analysts acknowledge that there's not much the Fed really can do to jump-start the economy beyond rate cuts. Some suggest, though, that working closely with the Treasury to encourage banks to start lending again might help.

"We're looking to the Fed for some intervention to help unlock the frozen CDO marketplace," says Alan Rosenbaum, president of GuardHill Financial in New York, a mortgage brokerage that does not deal in subprime loans. "Until that happens, banks are not going to lend."

"It's very difficult for banks to be in the lending business without access to long-term unsecured money," says Bill Isaac, managing director at LECG in Vienna, Va. "Bringing rates down at the short end I don't believe would be as effective as trying to find ways to make more lending available to banks. I don't have the answers. I'm sure that would have to be worked out by the Fed and the Treasury."

One such effort--special auctions allowing banks to borrow money cheaply from the Fed--has been only modestly successful so far. Though they attracted a lot of interest when they began in December, Thursday's auction was poorly received, with weak foreign demand sending prices on 30-year Treasury bonds plunging.

Perhaps the only solution to the credit crunch, analysts suggest, is time and patience.

CONTINUED : Next: The Fed's Catch-22

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