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The Fed Offers Wall Street A Band-aid ... But Have Bloodied Investors Learned A Lesson?
Posted on 08/23/2007 13:43:30 | Link | Post Comment
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On Friday global markets received a welcomed surprise when the Federal Reserve cut its discount rate by 0.5%. The discount window controls the rates that banks can lend and borrow money between one another.
While there is a distinct difference between the Fed Discount rate and the Fed Funds rate, the markets still took the surprise decision and ran with it. (See the next section, "Making 'Cents' of the Economic Headlines," for some more details on Friday's market moving news.)
But what exactly is fueling the market's rebound? In my opinion, it's not the direct effect of a discount rate cut at all. Instead, it's all psychological. There's Psychology behind the Fed Move ... but Not Much More
The Federal Reserve achieved their goal of market stabilization on Friday. By making this statement, the Central Bank allowed markets to see a light at the end of the tunnel. Unfortunately, cutting the discount rate was a much more conservative maneuver than the Street had in mind.
I Googled the term 'moral hazard' yesterday and got a link to Wikepedia as the first of more than two million hits. Here's what Wikepedia had to say ...
Moral hazard refers to the chance, or hazard, that a party in a transaction with more information about his intentions or actions behaves in a way that a party with less information would consider inappropriate, or in the extreme, "immoral". It arises because an individual or institution in a transaction does not bear the full consequences of its actions.
Now how about a current example?
The sub-prime mortgage mess and the global credit crunch that everyone's talking about happened for one reason and one reason only: Pure speculation driven by too much cheap money led to hyper-active trading in search of greater profits. In other words: Runaway greed led to euphoria. And as I'm sure you would likely agree, too much credit stems from reckless money management and irresponsible lending practices.
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To Cut or Not to Cut, That is the Question
So what about 'moral hazard'? Well, it's something the Federal Reserve might be struggling with. As they consider cutting the Fed Funds rate they'll risk pumping more funds into the system that would encourage further risk-taking and effectively condone the massive amount of irresponsible lending that's already taken place (no-money-down mortgage loans with teaser rates).
No matter where one stands on the Fed's performance, we all have to marvel at just how fragile our global financial network really is. We go to the brink and snap back. We've seen it again and again.
Everyone is so smart in hindsight. None of those meticulous machinations of proper policy matter in the midst of crisis. Only the lender of last resort matters in the darkest hour. That's because as a credit crunch progresses, it becomes disconnected from the fundamentals and morphs into a full-blown crisis of confidence in the system.
Even though we are told during the boom by new-era journalists and hedge fund heroes that the Fed just doesn't matter anymore, it all rings hollow when the Fed is the only institution capable of any modicum of success by sticking a finger in the dike.
A thankless job indeed it is. What have you done for me lately, Mr. Bernanke, seems the cat call from your average Wall Street type and their cheerleaders in the financial press.
We'll find out by September whether the Fed gives in to 'moral hazard' by answering Wall Street's calls for a rate cut, or if they'll act prudently and address monetary policy as they should.
I recommend the latter if they really want to teach the markets a lesson.
Regards,
Jack
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Making "Cents" of the Headlines
A Desperation Move by the Federal Reserve Stabilizes Markets ... For Now
What Happened:
The U.S. Federal Reserve slashed its discount rate by 0.5% on Friday
How Markets Reacted:
Global markets, struggling over the last few weeks due to rising credit concerns, rebounded sharply after the Fed opened the discount window and hacked the discount rate by a half-point. The dollar lost ground and some of the other major currencies rallied.
What I Say:
Basically, in an unplanned announcement, the Fed told banks that it's ok if they want to come borrow cheap money from Uncle Sam. This spontaneous rate cut temporarily injected more liquidity (money) into the system for banks to help cope with the credit crunch.
This desperation move by the Fed temporarily stabilized markets, but by no means does this cure the over speculation made possible by too much credit. I anticipate the selling will resume. When that happens, the dollar could see more of the safe haven bid its gotten over recent weeks and the Japanese yen could be boosted by a further carry trade unwind.
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