Monday, March 10, 2008

Federal Reserve gives emergency help to Wall Street banks

This article was first published on on Friday March 07 2008. It was last updated at 18:02 on March 07 2008.

Pure coincidence. That was the message from the Federal Reserve as it made the announcement that it was giving emergency help to Wall Street banks, just as dreadful employment numbers were announced.

If you believe that, as the saying goes, you will believe anything. The Fed knew about the fall in non-farm payrolls, knew what the reaction of the financial markets would be, and took pre-emptive action. The impact, though, was short-lived.

Wall Street has a touching faith in the omniscience and the omnipotence of the Fed, but it is not quite that gullible. So what is the explanation for the Fed's action?

There are three points to bear in mind. The first is that today's employment report is the clearest indication yet that the US economy is in recession, with the slump in the housing market spreading to other sectors.

The second is that the credit crunch has entered a new and potentially even more dangerous phase. Despite cuts in the Fed funds rates, interest rates paid by companies and individual borrowers have been rising as credit has become scarcer and, as a result, more expensive.

The Fed funds rate has been slashed from 5.25% last summer to 3% today — and will be cut again on March 19, but the fear is that the US central bank is, as Keynes once put it, pushing on a piece of string.

Finally, the Fed's apparent indifference to the current level of inflation in the US — the headline rate is well above 4% — has spooked investors in the foreign exchange markets. The dollar is in freefall, dropping to record lows against the euro and prompting a flight into the safe haven of gold.

This, of course, has added to the upward pressure on the cost of living and has made it more difficult for the Fed to come up with the sort of eye-catching cut in interest rates later this month that the markets were starting to price in.

In recent days, there had been speculation that Ben Bernanke, Fed chairman, might be persuaded to cut rates by 75 points later this month or even announce the second inter-meeting reduction in borrowing costs this year.

Today's decision to pump extra liquidity into the financial markets is a sign that this is not going to happen. Quite rightly, the Fed has taken the view that anything other than a half-point cut on March 19 would smack of panic and lead to a meltdown in the dollar.

In truth, though, that may still happen. The Fed would like us to think it is still in full control of events; the opposite is the case.

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