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.

Federal Reserve Bank Chairman Ben Bernanke
Pablo Martinez Monsivais
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.

Next: The Fed's Catch-22

A Diagnosis, But No Cure

Haag Sherman, chief investment officer of Salient Partners in Houston, Texas, wants the Fed to get out of the "appeasing mode" that leads to the rate cuts and let market forces take hold. He believes that the unwinding of the subprime losses will be the only thing that cures the ills that have befallen stocks and the economy.

"We're going through a period of correction, and I think ultimately the rate cuts will be counterproductive because the correction is going to happen regardless," Sherman said. "This is just a natural market-driven response to an asset and credit bubble."

Traders at the New York Stock Exchange
Traders at the New York Stock Exchange

Still, the Fed soldiers on.

There's consensus that the Fed Open Market Committee will approve a rate cut of at least a quarter-point at its March 18 meeting. And the familiar cycle probably will start anew -- rate cut, market bounce, market fall -- leading some to wonder how far the Fed will go until finally shutting off the rate-cut spigot.

"What happens when they lower it further and further and the market doesn't react to the stimulus?" Sherman wondered. "At some point a crack addict has to get off crack."

Those who doubt the effectiveness of the rate cuts assert that the market reaction has been overblown to the credit crunch.

"I think there's an irrational fear in the marketplace right now. I do not believe the banking system is in any kind of serious trouble," said Isaac, chairman of the Federal Deposit Insurance Corp in the 1980s and early 1990s during the savings and loan collapse. "Take it from someone who has seen a banking crisis up close and personal."

And not everyone believes the rate cuts are irrelevant.

Among those who think the Fed's rate cuts do matter are those who maintain the central bank should not be obliged to the stock market, and thus the effectiveness of the rate cuts should not be judged solely on the impact they have on stocks.

"The real goal of the Fed is to try to keep the economy from sinking into recession if they can do so without letting inflation get out of hand," said Daniel Siever, finance professor at San Diego State University. "The stock market is fixated on the Fed, but the Fed is not fixated on the stock market. Stock market commentators are the first to bash the Fed if the market goes down, and I think the Fed's feeling is we're not here to serve you."