When it comes to the credit crunch, the more things stay the same, the more the Fed changes.
In other words, don’t expect the central bank to cut interest rates on Tuesday at its regularly scheduled FMOC meeting following the Lehman Brothers-Merrill Lynch-AIG developments, even though that's the action it took in March when Bear Stearns was on the ropes.
The Fed has thrown a lot at the credit crunch since then, from aggressive rate cuts to creative new lending facilities, during which time it has also learned to adapt and improvise.
“The Fed has been separating credit facilities and interest rate reductions for sometime now,” says Robert Brusca, chief economist at Fact & Opinion Economics. “If interest rates were higher there might be some sense in lowering them, but they're not. I think the Fed wants to keep that powder dry."
But the market seems to be going with a different scenario. On Monday the market was pricing in a 67% chance of a quarter-point cut, based on closing prices for fed funds futures contracts on the Chicago Board of Trade. Overnight that jumped to 88%.
The Fed was clearly taking other steps. On Tuesday, it added some $50 billion in reserves to the US banking system in a move to improve liquidity, following $70 billion in is open market operations Monday.
As the FOMC meeting Tuesday, economists and investment strategists, however, do expect the Fed to change its balance of risk assessment in the FOMC statement, saying it is more concerned about economic growth and financial system stress than the threat of inflation, its most recent focus.
“Risk to downside has increased,” says James Awad, managing director at Zephyr Management. "They tilt risk to the downside, a tilt toward ease.”
Those downside risk may warrant future action, which is why market analysts say the Fed wants to keep some of its monetary ammunition, having slashed its federal funds target rate three and a quarter percentage points to 2 percent in the last 13 months. (There's also the possibility that the Fed Tuesday will trim its discount rate, now at 2.25 percent.)
What the FOMC does and says Tuesday will also likely reinforce both a change in the Fed’s role as well as a more broader policy change with the credit crunch.
“From a traditional standpoint it has added to liquidity … and taken steps to alleviate the crisis of confidence,” says Standard & Poor’s Chief Investment Strategist Sam Stovall. “It’s come to a point, where the Fed has said we're not going to bail out everybody.”
As a result, Lehman Brothers has filed for chapter 11 bankruptcy protection, Merrill Lynch has agreed to be acquired by Bank of America for a song and AIG is trying to survive on its own to survive a credit downgrade, whereas Bear Stearns was saved from extinction by a Fed-Treasury engineered buyout by JPMorgan Chase.
In a statement, the Fed said it was expanding the lending facilities it created or altered at other stages of the credit crunch, which it hoped would “mitigate the potential risks and disruptions to markets.”
The central bank added that the changes “should enhance the effectiveness of these facilities in supporting the liquidity of primary dealers and financial markets more generally.”
The Fed “feels reasonably confident the various credit facilities it has put in place are up to the task of meeting the liquidity needs of the system.”
Others say that's still not enough.
"The facilities are fine, but the idea that 2 percent is a magic anchor that you throw into the ground and then hope all other rates go to is folly," says Kevin Ferry, CNBC contributor and co-founder of Cronus Futures Management, who adds that a fed rate cut is already built into the market and a failure to cut will be problematic.
The system, of course, is one thing; investor psychology is another. As the Fed witnessed during this credit crunch, a dramatic global selloff can be a systemic threat of its own, which might require its own timely medicine.
If the stock market selloff snowballs Monday, then all bets are off. "You almost have to throw in the kitchen sink,” says Awad. “You do a rate cut with a statement you take it away as soon as you can. It provides psychological support to consumers and the financial system."