September 17, 2008

WASHINGTON — Federal Reserve policy makers, putting concerns about inflation ahead of the financial turmoil, kept the benchmark lending rate unchanged at 2 percent on Tuesday.

The Fed board faced one of its more difficult decisions of late, whether to hold the rate steady in deference to concerns about inflation, or cut it to help ailing banks and restore investors’ confidence in the financial sector. On Tuesday, the board seemed to come down on the side of controlling inflation.

Until a few days ago, the prevailing sentiment was that the Fed would keep rates steady. But the events of the last few days changed all of that.

As Fed policy makers began their meeting Tuesday morning, global financial markets were enduring a second day of turmoil. Asian stock markets, most of which had been closed on Monday, had plunged 4 percent to 6 percent as they absorbed the weekend shocks involving the investment banks Lehman Brothers and Merrill Lynch, and the insurance giant, the American International Group.

On Friday, when it seemed likely that Federal officials would orchestrate some kind of shotgun marriage for Lehman Brothers, investors had assumed that the Fed would leave its benchmark rate unchanged at 2 percent.

The Fed chairman, Ben S. Bernanke, had sent out a steady stream of cautionary warnings that inflationary pressures remained a concern. The overnight Federal funds rate was already lower than the inflation rate, which meant that the “real” rate was below zero after adjusting for inflation.

The Treasury Department’s bailout on Fannie Mae and Freddie Mac, the government-sponsored mortgage finance companies, promised to provide additional relief. That move, which reduced anxiety about mortgage securities that Fannie and Freddie had guaranteed, had reduced the yields that investors were demanding on the securities and seemed likely to reduce the cost of mortgage borrowing.

Fed officials had already lowered rates on the assumption that economic growth would slow to a crawl in the last few months of the year, so it did not seem likely that they would reduce rates again when the slowdown appeared. But the turmoil of the last couple of days raised the possibility that the Fed’s gloomy forecast may be too optimistic and that it would have to take additional action.

By any measure, the economy has already slowed sharply. The United States lost an average of 75,000 jobs a month since January, for a total loss of 605,000 jobs through August. The unemployment hit 6.1 percent last month, up from 4.9 percent in January.

Some sectors, especially exports, have been surprisingly strong. Exports have gotten a lift from the dollar’s sharp drop against other currencies, which makes American products cheaper overseas, and from healthy growth in other parts of the world.

But most forecasters predict that the export boom will probably fade as slower growth in the United States spills into foreign markets.

Meanwhile, the United States economy faces a pounding from the continued debacle of the housing market and the hugelosses in financial markets.

The collapse of the mortgage market will probably extend the credit crunch for two separate but mutually reinforcing reasons. The first is that banks and investors have already been forced to significantly tighten their lending standards.

Subprime mortgages and other high-risk loans, which accounted for almost a third of new mortgages in 2006, have all but disappeared and are unlikely to return any time soon.

Beyond that, banks and financial institutions now have to repair the holes in their balance sheets. That is a process that could take years, and could be even more difficult if foreign investors, including foreign central banks, become more reluctant about financing America’s huge foreign debt.

Traditionally, the Federal Reserve has been reluctant to change interest rates just before an election, because officials do not want to invite accusations of trying to influence political outcomes.

But by Monday, panicky investors and shell-shocked analysts were clamoring for a cut. The possible collapse of A.I.G. raised the prospect of untold billions of dollars in defaults on credit-default swaps — insurance contracts that protect investors against losses on bond defaults.

Treasury officials were working with Goldman Sachs and Morgan Stanley to line up bridge loans for A.I.G. while it regrouped by selling some assets. Goldman Sachs, meanwhile, announced on Tuesday morning that its third-quarter net income had plunged 70 percent compared to one year earlier.

Prices of Federal funds futures, a gauge of what investors think the Fed will do, showed that traders had bet on a quarter-percent drop in the overnight Federal funds rate.

Several economists, including David Rosenberg of Merrill Lynch and Robert Di Clemente of Citigroup, predicted that the central bank would lower its base rate by one-half of a percentage point, to 1.5 percent.

For Fed officials, a crucial issue has been credit “spreads,” the risk premiums that investors are demanding on debt ranging from corporate bonds to mortgages.

Those spreads had been widened sharply, prompting some Fed officials to worry that their previous rate cuts had been largely nullified by the increase in market anxiety.

The president of the Federal Reserve Bank of San Francisco, Janet Yellen, warned in a speech last week that even through investors were demanding greater safety and higher yields across an entire spectrum of debt financing.

“Dramatically wider yield spreads on credit default swaps, which provide insurance against default on the underlying securities, are further evidence of increased risk aversion in financial markets,” Ms. Yellen noted.

“Of greater relevance to monetary policy are movements in the borrowing costs facing households and firms,” Ms. Yellen added. Though interest rates had edged down for the traditional “conforming” mortgages guaranteed by Fannie Mae or Freddie Mac, she said, increased risk-aversion among investors had keep rates high for almost every other kind of mortgage, including larger “jumbo” mortgages for people with high credit scores home and home-equity lines of credit.

No More Creampuffs
The Government Is Willing to Let Wall Street Firms Fail. That's Good.

By Kenneth Rogoff
Tuesday, September 16, 2008; A21

This past weekend, the U.S. Treasury and the Federal Reserve finally made it abundantly clear that they won't bail out every significant financial firm in America. Certainly this came as a rude shock to many financiers. In allowing the nation's fourth-largest investment bank, Lehman Brothers, to file for bankruptcy, and by forcefully indicating that they are prepared to see even more bankruptcies, our financial regulators showed Wall Street that they are not such creampuffs after all.

The question now: What's next? Assuming the financial sector continues to melt down over the next couple of months, at what point, if any, should the government get back into the game? It would be a mistake to do so before a great deal more consolidation takes place. During the epic boom of the past 20 years, the financial services sector became badly bloated. At its peak, it accounted for over one-third of corporate profits in the United States, not to mention the staggering billions of dollars in bonuses that Goldman Sachs ($12.1 billion in 2007) and others paid their employees. Now, in the wake of the subprime mortgage debacle, investment banks are seeing some of their most profitable lines of business evaporate. Profits from complex mortgage products are not coming back anytime soon; nor are profits in many other areas that rely on huge borrowing.

Instead, "deleveraging" is the buzzword throughout the financial system, as firms prune their borrowing and their positions. As profits come down to more earthly levels, the U.S. financial system is going to shrink. In all likelihood, at least 15 percent of financial employees -- including at the high end -- are going to lose their jobs. In principle, this shrinkage could take place through all firms and banks trimming their operations proportionately. But that is not how a capitalist economy operates. Whether it is the auto, airline or tech industries, the strong devour the weak. That is why it was inevitable that some banks would either fail or submit to distress mergers, including even some of the largest. That is why it has been quite clear for some months that the trauma to the U.S. financial system was not over.

Letting a big investment bank go, as the Fed and Treasury did this weekend, was a calculated risk in a difficult situation. And the risks are very real. With the immense interconnectivity of the financial system, there really is no telling where the unprecedented failure of a big investment bank might lead. On the other hand, ponying up tens of billions in tax money, as the Federal Reserve did in March when another investment bank, Bear Stearns, collapsed, is no answer, either. With the housing market still weakening, with U.S. exports likely to suffer as the global economy falters and with unemployment rising, it is clear that simply bailing out Lehman Brothers would not stop the rot in the financial system.

In March, the Federal Reserve took on $29 billion in risky Bear Stearns assets. Bailing out Lehman probably would have involved at least as large a commitment. If such a maneuver could have put an end to the crisis, it might have been justified, but that is hardly the case with many other giants teetering. This is not to mention the trillions of dollars in liabilities the Treasury took on 10 days ago in bailing out the mortgage giants Fannie Mae and Freddie Mac. These alone will probably end up costing taxpayers $100 billion to $200 billion, assuming inflation-adjusted housing prices fall another 10 to 12 percent.

Will taxpayers now escape without further damage? Probably not. More likely, the stress will continue for some time, radiating out into corporate debt, hitting big automakers, many debt-strapped cities and others. At some point, the federal government will blink again, and taxpayers will probably end up paying at least another couple hundred billion dollars before this extraordinary mess ends. But by placing some of the burden on the shareholders and bondholders of the big financial institutions, financial regulators have at least forced some discipline onto the system, making bankers and investors think twice before they once again head off to the races. By allowing firms that took excessive risks to fail, regulators also reduce the political pressure to overregulate the system in the aftermath of the crisis. Let's hope they hang tough for at least a little while longer.

The writer is a professor of economics at Harvard University.