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
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.
“It’s not that banks lack liquidity,” says Ely, “It is the credit quality of borrowers. There's a lot of lender uncertainty out there in terms of downside risk. The credit outlook for next few years is not that good."
Ely says there are another two to three years of adjustment in prices, before a bottom has been reached. If so, that has profound ramifications for homeowners and lenders.
Time To Form A Bottom
So far, no brave--or optimistic soul--is ready to call the bottom. But more uncertainly brings more inactivity--and more uncertainty--which feeds into the overall economic slowdown.
Money manager James Awad says the Fed should cut rates another half a point to 2.50 percent next week and “make it loud and clear” the rate cutting is finished.
Awad thinks that will help start the process of setting a bottom. There may be another round of pain and panic, but it will trigger asset re-evaluation and bring in the buyers, the likes of Warren Buffett, Wilbur Ross and JPMorganChase,, which just happened to be there for Bear Stearns.
“The market has to stop squealing and let the process work itself out,” says Awad, chairman of WP Stewart Asset Management.
Others say the Fed simply can’t do that and has to be prepared to keep cutting, even it real interest rates become temporarily negative--something the Fed’s January FOMC signaled it was prepared to do and which it has done during other recessions.
Of course, there’s a growing consensus that while this recession may be your cyclical downturn, the credit crunch is a one-of-a-kind crisis, far more ominous that the balance sheet problems associated with the 1990-1991 recession, which followed a lending mess called the savings and loan crisis.
“The Fed by itself cannot get us out of this,” says the Economic Policy Institute’s research director, John Irons, who is among a growing group pushing for a variety of fiscal measures to complement monetary policy.
That’s what makes the Fed’s most recent mortgage market move so telling, even if somewhat limited.
Bernanke has also taken the somewhat unusual step of backing plans to help troubled mortgage holders along with a batch of proposals to tighter regulations on lending that he unveiled hours after the Bear Stearns bailout Friday.
For all the second-guessing and criticism Bernanke has been subject to, there’s a grudging but growing approval of his handling of the recession-credit-crunch dynamo. He’s doing both the expected and the unexpected, and the latter of the two is what has distinguished Fed bosses over the years.
That said, it may nevertheless be a fight Bernanke can’t win--and that may actually be a good thing.
“Let the bubble burst, let prices go back to the right level,” says Mitchell of the Cato Institute. “Once it happens everyone will have greater certainty. Banks will know what their loans are worth. Homeowners would know what their loans are worth.”