Fed Tries To Stem Crisis, But It May Not Be Enough

Fed Chairman Ben Bernanke is throwing all he’s got at the economy, but it may not be enough to combat both a recession and credit crunch.

Having won praise for their latest two measures to spur lending, Bernanke and company had little time to rest on their laurels. On Friday, the central bank was forced to provide emergency funding to Bear Stearns , which has been struggling with its large portfolio of mortgage-backed securities.

Sure enough, the latest flare up triggered new speculation about another inter-meeting rate cut, just days before the Fed’s FOMC convenes for its March meeting, where it was already widely expected to slash rates for the third time this year.

And along with the usual question of how big of a cut--one-half, three-quarters, or even a full

Dennis Cook / AP Federal Reserve Board Chairman Ben Bernanke delivers the board's Monetary Policy Report to the Senate Banking Committee in Washington Wednesday, July 19, 2006. "The recent rise in inflation is of concern," and possible increases in the prices of oil as well as other raw materials "remain a risk to the inflation outlook," Bernanke said. (AP Photo/Dennis Cook)

point, as some clamored for Friday amid the hysteria--there’s another question: Will all the Fed’s moves do any good?

“I really question how much of an impact the Fed has had,” says bank analyst Bert Ely, president of Ely & Co. “Asset values are determined by more than the Fed's short term rates.

No Pain, No Gain

Ely is part of a growing chorus of skeptics who say the US economy is going through a painful “balance sheet correction” --from banks to consumers--that is not only overdue but inherently needed.

What’s more, there's worry that the Fed’s aggressive rate cutting and other liquidity measures are making the situation worse by postponing the inevitable. That's on top of concerns that central bank is setting the table for a nasty spike in inflation down the road--despite the unexpected good news on consumer prices on Friday.

"The Fed cuts are bad for the economy; it’s the equivalent of having a hangover and needing a drink to cure it," says Dan Mitchell, a senior fellow at the Cato Institute. “We have a bad mortgage market because we had a bubble. There's nothing we can do other than let things return to their market levels.”

The same could be said about other asset values and the balance sheets of the financial companies that loaned money – widely and sometimes unwisely – as well as those that bought a veritable shopping cart of  debt.

Until this week, when the Fed moved to inject liquidity into the stalling mortgage market, the bulk of its efforts--from lower fed funds rates to the conventional discount window borrowing mechanism to a newly created auction vehicle--were meant to stimulate activity among major banks as well as between banks and borrowers. Lenders were indeed shoring up their balance sheets but they weren’t lending enough.

“The problem is not the cost of funds overnight,” says David Resler, chief economist at Nomura International, who adds that the Fed’s previous efforts “didn't enable funds to get down the chain from the Fed to the banks to the system.”

Victory At Any Rate

Instead, aggressive rate cutting triggered inflation alarms, pushing the spread between the 10-year Treasury note and 30-year mortgages from about 160 basis points in January -- when mortgage rates appear to have bottomed -- to 240 basis points more recently. Mortgage activity slowed as consumers experienced sticker shock.

The Fed’s move this week allowing the central bank to take $200 billion in some mortgage loans and mortgage backed securities from banks as collateral for 28 days should help narrow that spread in the weeks ahead.

Though investors and analysts validated the genius of the move with an enormous stocks rally, it’s the latest sign from the Fed that this is not business as usual.

“The Fed is addressing something “pretty much new,” says Christopher Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi. “This is definitely a credit market meltdown.”

And that’s where all the doubt comes in. Liquidity is not necessarily going to fix that.

CONTINUED: "Credit Oultook for the Next Few Years Is Not Good."

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