Bernanke's Bind: No Easy Answers

Updated from 7:14 a.m. EDT

Federal Reserve Chairman Ben Bernanke has been sandwiched between creating a crisis and preventing one. As the Fed injected liquidity into the system three times by Friday afternoon the markets were putting the Chairman more in the crisis-prevention camp.

Based on Tuesday's "tough love" statement, the Federal Open Market Committee seems to be taking a calculated risk that the current financial crisis won't become an economic one. As the markets and banks rumble through the uncertainties of this credit crunch in part by scrambling for cash, the Fed seems to be doing its best to support the financial system without convening an emergency meeting of the FOMC to make rate cuts.

"Like everyone else, [central banks] face uncertainty about the future (most of which is shared uncertainty), but, unlike almost anyone else, they must maintain an aura of wisdom, of being in control, almost as if they did know (a lot) more about the future than the rest of us," writes Ethan Harris, chief economist at Lehman Brothers. "They do not."

The markets are buying the aura of wisdom to some extent, but it wasn't until the Fed's second round of $16 billion came into to the markets at about 11:00 a.m. that investors finally felt a confidence boost.

"It can be said about the Fed that for the first time, it acted preemptively, an action obviously taken favorably thus far in the financial markets," writes Tony Crescenzi, chief fixed income strategist at Miller Tabak about the Fed's second action.

The Dow Jones Industrial Average had been down over 200 points at its worst point Friday, but rebounded sharply, even touching green briefly. The Fed's liquidity offerings and a statement released Friday designed to sooth the markets may have stemmed the downturn, but traders remain unconvinced that the credit market problems are over. Stocks were floundering again in recent trading with the Dow down about 100 points.

The Fed had injected $35 billion earlier in the day, after $24 billion on Thursday morning. At around 1:50 p.m. Friday, the Fed set up a third operation to offer an extra $3 billion into the system, seemingly to ensure liquidity enough for the weekend. The special actions are the greatest the markets have seen since after the Sept. 11, 2001 terrorist attacks in New York. The Fed added a daily average of $75.3 billion in the week after the attacks, Bloomberg reports.

In the wake of the world's markets' rout and sense the credit crunch is going global, the fed funds futures market now prices in 100% odds of a 25 basis-point rate cut at the Sept. 18 FOMC meeting, 100% odds that the Fed will cut rates twice by the end of the year, according to Miller Tabak.

But, the nature of the problems in the financial system, perhaps the Fed chief and his central bank minions can't do much about current market upheaval but to offer such liquidity injections. An emergency meeting and rate cuts wouldn't solve the problems underlying the drama and could actually serve to exacerbate them. But, the extra cash does help the banks weather the storm, and it bides them some time as they work to grasp the magnitude of the current problem.

The extra liquidity is offered because banks have been driving up the overnight cost of funds they lend to other banks. That rate is intended to be at the fed funds rate or Libor, or any country's target funding rate. When it goes higher it is often in part because banks are worried about their own problems and imagine the bank they're lending to must be in worse shape. The game is part protection, part discovery process. The central bank actions bring back the rates to normal levels by offering up more supply to meet the demand for cash.

"The easiest way for a bank to determine if another bank is having liquidity issues is to charge higher rates to the banks they lend to," says Jeffrey Saut, chief equity strategist at Raymond James.

But, a rate cut -- even two -- probably won't help fund managers or banks figure out how to value the esoteric securities on their balance sheets known as collateralized debt obligations (CDOs). A 25 basis-point rate cut probably won't help the titans of Wall Street sell the over $250 billion of loans they're storing on their balance sheets.

Wall Street debt underwriters committed this financing to private-equity sponsors doing leveraged buyouts months ago, when risk premiums were much tighter.