PRINTMarket Update -- Economic Comment
September 12, 2007
The Fed made it clear at the recent Jackson Hole symposium that they stand ready to take additional actions to promote the orderly functioning of financial markets. Chairman Bernanke also made it a point to state in his opening address that the Fed does not believe it is their responsibility (or appropriate) to "protect lenders and investors from the consequences of their financial decisions." Bernanke warned, however, that sustained gridlock in the credit markets "would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally."
These viewpoints, which are probably widely shared by all FOMC members, are also the very wedges that could divide the FOMC on September 18, making it hard to reach an agreement about the proper course of action. So, while the markets are counting on the FOMC to get the bogged-down credit markets unstuck, there is a fair chance that the FOMC will get mired as well.
FOMC member Dennis Lockhart aptly described the situation in a September 6 speech. "I believe the essence of our current challenge is to balance three interconnected and potentially conflicting concerns: timely action in response to risks to the total economy, preservation of gains achieved on the inflation front, and overall financial system stability." He went on to say that the Fed must concentrate on balancing their response to current problems with the need to achieve the best outcome for the long run. Lockhart's points get to the heart of the current problem; the Fed is loath to create moral hazard by bailing out those who overindulged in risk, but they cannot stand idly by and allow financial gridlock to seriously disrupt economic growth. There is no obvious policy prescription to this problem.
Chairman Bernanke will work very hard to form a consensus at the September 18 FOMC meeting because the impact of a rate cut on the financial markets will be diluted if the FOMC statement reveals any dissenting votes. We think the compromise will be a 25-basis point cut in the funds rate to 5% accompanied by a 50-basis point reduction in the discount rate to 5.25%. We would prefer that the Fed take a stronger action but suspect there will be too much resistance to achieve one. The FOMC statement could amplify the impact of a smaller cut if it portends additional cuts down the road. The main goal right now is to restore confidence in the financial markets, and this is not necessarily a product of the actual funds rate level but more a function of the willingness of investors and lenders to come out of their bunkers. Our main concern is that Bernanke might fail to achieve a consensus, and the FOMC decides to leave monetary policy unchanged. This outcome could cause financial market participants to dig even deeper into their bunker...and wave the white flag.
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