Outside editorial: Federal Reserve may be dancing in the dark

Posted: Wednesday, December 19, 2007

Wall Street is a fickle audience, but rarely does it jeer and cheer the same fellow within 24 hours. It gave just that treatment last week to Ben Bernanke, chairman of the Federal Reserve.

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He was the street's goat on Tuesday, when the Fed cut short-term interest rates by a mere quarter of a percent, instead of the half-percent traders had been hoping for. The Dow Jones Industrial Average dropped 294 points.

On Wednesday, Mr. Bernanke announced a plan to pump $40 billion worth of grease into the nation's increasingly creaky banking system, hoping to head off a major credit crunch. The Street liked it. Up went the Dow by 41 points.

In truth, both moves present a measured approach to an economy facing an unusual set of problems.

"The Fed is feeling its way in the dark here; current conditions are unprecedented in modern times," wrote Ian Shepherdson of High Frequency Economics.

At the moment, the economy's pulse still is beating quite strongly. Unemployment is still low at 4.7 percent, and November retail sales were up a surprisingly strong 1.2 percent. But forecasters, including those at the Fed, think things will slow considerably next year, weighed down by falling home prices, rising foreclosures and a possible credit crunch. Most forecasters see the economy avoiding a recession, although it's becoming a closer call.

Given the uncertainly, the Fed has cut short-term interest rates by a full point since September. Lower rates usually make it easier to borrow and spend, adding steam to the economic engine. But the other worry is inflation. Consumer prices are up 4.3 percent over the past year. Much of that is energy prices, but it's still a scary number. Sharp price increases in November indicate that inflation isn't going away.

Interest rate cuts take six months to more than a year to work their way through the economy. If the Fed cuts too much now, it risks setting off a wave of inflation as the economy pulls back out of its slump next year. So the Fed is trying another tactic to prevent recession; throwing a net under the banking system.

Banks and financial firms are losing billions on their subprime mortgage investments. So, banks are sitting on cash rather than lending it to other financial companies. They're afraid that other big players may go belly up and be unable to repay their loans. This anxiety is the real danger. If it spreads, it could clog up the entire credit system, denying credit to businesses and consumers and bringing on a recession.

Since August, the Fed has been trying without much success to push money into the banking system. The goal is to restore confidence and get the credit markets working normally again. As Alan Skrainka, chief market strategist at Edward Jones, put it: "The main problem in credit markets has not been that rates are too high, but that financial institutions have been unwilling to lend."

Last week the Fed made its credit offer harder to resist, announcing it will lend $40 billion to banks and accept collateral that others fear to touch, including subprime mortgages. In effect, the Fed hung out a sign reading "Cheap loans! No credit, no problem."

Unfortunately the Fed can't remove the underlying worry: There's too much subprime debt out there; some big financial companies may actually go broke. Until that shakes out, the credit markets will remain sticky.

The Fed also is joining forces with central banks in Europe, which also are suffering a credit crunch. The aim apparently is to drive down the benchmark dollar lending rate in Europe, which has remained stubbornly high. That's bad news for Americans because a huge number of U.S. adjustable-rate mortgages are linked to that European rate.

It's too early tell if Mr. Bernanke and the Fed, dancing in the dark of these unprecedented conditions, are taking the right steps. But slow and measured is the right pace.

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