Fed Responds to Risky Business

Conn Carroll /

Despite the Fed’s bold and timely moves, the U.S. economy overall has at best entered a period of slow growth, and may be teetering on the edge of recession if one is not already at hand. Two major sectors of the economy – housing and financial markets – are in severe recession, and it is unclear that the other elements of the economy, especially business investment and the health care and net trade sectors will be sufficient to stave off an actual overall contraction.

While the underlying fundamentals of the economy strongly suggest that it will recover and return to robust growth, the length and depth of this period of weakness is unclear, and will depend significantly on the actions of the Federal Reserve in the days and weeks ahead.

To date, the Fed is to be commended innovative actions to keep financial markets operating in very difficult circumstances. A good example is the Fed’s husbanding over the weekend of the sale of the investment firm Bear Stearns to J.P. Morgan. In this event the Fed properly used it powers to fold an investment bank whose weakness posed a potential risk to the financial system. In a further move that was not as widely commented upon, the Fed also established a new Primary Dealer Credit Facility that will allow it to directly offer liquidity assistance to certain investment banks that were not previously eligible for it. This move signals the Fed’s determination to strengthen certain investment banks and avoid a potential panic about the overall condition of the financial system.

The shift in roles at the Fed is important. In more normal times, the Fed would with changes in the Fed Funds rate content itself assuring the financial system has sufficient liquidity to work through its troubles. More recently, the Fed has ensured that specific troubled markets, such as those for commercial paper or mortgage backed securities, had sufficient liquidity. In the Bear transaction, the Fed acted to ensure that a major institution had sufficient liquidity and temporary capital to stay in business until it could be closed in an orderly manner. Operations involving capital are very different in mode and consequence from those involving liquidity. In the Bear case, the sale to J.P. Morgan wiped out the firm’s equity, but without the Fed’s intervention, the outcome could have been even worse for the financial system as a whole.

The great uncertainty in the coming days will be whether those firms that find themselves in similar straits as Bear Stearns, and there will likely be such firms, can find similar White Knights in time. And this, in turn, will depend on whether the Fed can find sufficient pools of unencumbered private capital. If so, then the current slowdown in the economy will pass painfully, but fairly briefly. If not…

The Fed has a second task before it, however, that may be at least as difficult, and once again a recession hangs in the balance. In recent months the Fed and other major central banks across the globe have acted aggressively to increase liquidity in the financial markets. This has created a risk of rapidly rising inflation and inflationary expectations. The world’s central banks will need to act aggressively, and likely sooner than they would otherwise like, to begin to drain this liquidity quickly at a measured pace. This will be a very dicey business, because if it acts too slowly, then higher inflation will take hold; but if it acts too aggressively, it will trigger a classic recession.