Updated from 1:10 p.m. EDT
The federal government has pulled out all the stops to stanch the bloodletting on Wall Street of late, but a growing chorus is saying the
needs to go back to a staple in its playbook: a good, old-fashioned rate cut.
Global credit markets remain frozen, despite heavy handed moves like the $700 billion financial bailout plan enacted by Congress last week and several other moves by the Fed to inject liquidity into the markets, including plans to begin buying
and increasing the size of a program that allows banks to borrow
in exchange for less liquid securities and other collateral.
Fed Chairman Ben Bernanke has thus far resisted a growing call for lowering the fed funds rate, in favor of the central bank's current approach, which he believes will be easier on inflation.
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"Paying interest on reserves should allow us to better control the federal funds rate, as banks are unlikely to lend overnight balances at a rate lower than they can receive from the Fed," Bernanke said in prepared remarks to the National Association for Business Economics in Washington, D.C. "
Thus, the payment of interest on reserves should set a floor for the funds rate over the day."
Still, Bernanke did not say a target cut was out of the question, noting that "
so long as financial conditions warrant, we will continue to look for ways to reduce funding pressures in key markets."
The pressure to cut, however, is mounting. The futures market had been predicting the Fed will slash rates before the end of October, perhaps at its meeting on Oct. 29. Such a move would further help strains in the credit market, and would follow a cut from Australia's central bank, which spurred hopes that the U.S. and Europe would follow its lead.
Bill Gross, the influential chief investment officer of Pimco, suggests that the Fed should cut rates drastically, to 1% from its current 2%, along with its purchases of commercial paper, as part of a broader strategy to save the market.
"A systemic delevering likely requires a systemic solution, which moves beyond cyclical interest rate cuts, liquidity provisions, or even the purchase of subprime mortgage-backed bonds," Gross writes in a note. "We believe that the Federal Reserve must now act as a clearing house, guaranteeing that institutional transactions clear (and investors receive)" their dues.
In theory, a lower target rate for interbank lending should also drive rates lower for consumer and business loans, notes Bob Pavlik, chief investment officer of Oaktree Asset Management.
"If you were able to lower interest rates, some of those people who aren't able to stay in their house or make payments on their house or credit card would get a hand," he says. "People don't have the same ability to borrow as they did in housing boom, because they don't have the same amount of equity in their homes. It would make people feel more secure with lower rates. I think all of these steps that have been taken
by the Fed could all work together."
President George Bush also sought to tie recent economic policy decisions into the average consumer's life, explaining that a person trying to buy a big piece of furniture may not be able to acquire a loan because the debt market seizure has trickled down from lofty national banks to the consumer and his local store.
"When credit runs dry in our country, it's a chain reaction," says Bush, adding later that "a lot of the talk you're hearing about the credit crunch directly affects you."
But Brian Dolan, chief currency strategist at Forex.com, notes that the Fed started a rate-cutting campaign in September through April, and the credit crisis has only exacerbated, with the availability of consumer credit constricting.
"That would be the hope, but in practice, the effect of Fed rate cuts coming down to the Main Street level has not been happening," he notes. "Banks are holding back on giving loans, so it's not about the cost of money it's about the availability of credit."
The Federal Open Market Committee has held rate steady at 2% since April 2008, as the central bank has avoided cutting rates due to concerns about inflation, which remains above 5%, a level not seen since the early 1990s. The FOMC had cut its target rate 325 basis points over the prior seven months. The U.S. target rate of 2% is still less than half the rate of other countries -- Australia's rate is now at 6%, the European Central Bank's is 4.25% and the Bank of England's is at 5%.
At the most recent meeting of the Federal Open Market Committee, which decides monetary policy, participants noted that inflation concerns had moderated but that stresses on the financial sector had increased, and marked down their near-term outlook for economic activity, according to minutes released Tuesday afternoon.
However, members attending the Aug. 25 meeting noted that while no rate cut was warranted at the time, "a policy response could be required" if "intensifying financial strains led to a significant worsening of the growth outlook."
Bernanke told the National Association for Business Economics gathering on Tuesday that despite a swift drop in commodity prices recently, the outlook for inflation remains unstable. He noted that prices can change quickly and unexpectedly and that "inflation numbers are very ugly right now," based on recent data.
While noting that "clearly the markets agree that inflation risks are lower," Bernanke added that "we have to be very careful not to declare victory."
But with the credit freeze threatening to exacerbate an already gloomy economic situation -- in which banks are hesitant to lend to one another, much less a consumer who needs a loan -- those concerns may not carry as much weight. That is especially true, with inflation fears largely diminished as commodity prices have tumbled far below their summer heights.
The large-scale government intervention into the financial sector comes as a slew of banks have crumbled, been bailed out or sold on the cheap due to massive strains in the housing and credit markets. Investment banks
( FRE) and
required government bailouts.
The nation's largest thrift,
, failed and parts sold to
( MER) and
sold themselves on the cheap, as their stocks came under assault.
, proved Monday that even the strongest in the sector are having difficulties. The country's biggest bank said third-quarter earnings plunged 82%, and that it would raise $10 billion in a stock offering while cutting its dividend.
Tony Crecsenzi, chief bond market strategist at Miller Tabak +Co., says that despite all the government's initiatives this week to improve the credit crunch, the markets still "clamor for
the simplicity of rate cuts."
"A cut of 75-100 basis points would do the trick for now," Crecsenzi said in an e-mail Tuesday afternoon. "A large cut is the best choice considering the gravity of the situation... Moreover, as investors in banks, we the public have a vested interest in the profitability of the banking sector now more than ever."
Crecsenzi says that taxpayers will benefit from a rate cut by improving the financial sector's health anyway, since they are financing the $700 billion rescue plan and receiving equity stakes in exchange.
What is good for banks is good for taxpayers," Crecsenzi said in an email Monday.
Still, those looking for a sustained stock-market recovery should look beyond a potential rate cut, experts say. Dropping the fed funds rate might ease credit constraints, but will not have a significant impact on the credit markets -- where fears about fundamentals seem to be overriding any government monetary policies -- or on stocks, which are pricing in a recession, hard and fast.
With stocks flip-flopping hundreds of points in either direction in a single trading session, sometimes counterintuitively, it is difficult to predict how much a rate cut will help -- if at all -- in the near term.
"The stock market is so volatile right now that it can go up or down for any reason at all, almost regardless of what happens to the fed funds rate," says David Levine, professor of economics at Washington University in St. Louis.
Still, Levine notes, the Fed, as well as other government agencies, have been making lots of moves in recent months to shore up the financial sector, except for a rate cut. "It's funny," he notes, "because it's usually the tool they use for open market operations."
Dolan says that Bernanke probably won't give any indication of rate-cut plans in his speech on Tuesday, and expects a 25-basis-point cut this month, at most.
"Certainly the market is clamoring for rate relief," says Dolan. "But will it have any effect? From the psychological standpoint it will have an effect. Whether it will actually do anything for the underlying problem -- which is basic credit market risk and counterparty risk -- that remains to be seen."