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Fed Befuddles Market

Is this what the central bank means by transparency?

What does it mean to ease monetary policy?

Don't ask the

Federal Reserve

, because it seems slightly unsure at the moment.

On Tuesday, traders sold stocks and bought bonds, believing the Fed was not willing to ease key interest rates enough to relieve credit market pressures. Less than 24 hours later, the message from the Fed is the reverse, but through enhanced liquidity injections -- and all in the name of stabilizing financial markets.

This all comes from Fed Chairman Ben Bernanke, who has spoken often in his nearly two-year tenure about ways to improve communication and transparency at the Fed.

Wednesday morning, the Fed announced a coordinated effort with foreign central banks to create a temporary system that will inject over $40 billion of liquidity into the financial system for periods of 28 days. In the accompanying statement, the Fed added that "experience gained under this temporary program will be helpful in assessing the potential usefulness of augmenting the Federal Reserve's current monetary policy tools." The Fed said it expects to seek public comment on making this temporary auction program permanent.

"Does this mean traders should watch for clues that the Fed might use the term auction facility instead of reading the FOMC statement or worrying about rates?" says James Bianco, president of Bianco Research.

The Fed, the Bank of Canada, the Bank of England, the European Central Bank and the Swiss National Bank announced plans Wednesday morning to create a term auction facility to add more than $40 billion of liquidity in four separate operations. As the Fed puts it, the move is "designed to address elevated pressures in short-term funding markets."

To say that traders were flummoxed would be an understatement. Market participants have spent the day wondering why the Federal Reserve wouldn't have made this announcement Tuesday ahead of their decision to cut the fed funds rate by 25 basis points to avoid roiling the markets. The Fed's official line was that the central bank wanted to be fair and make the statement when European markets were open.

"It is very strange, and raises more questions than it answers," says Michael Darda, chief economist at MKM Partners.

A New Influence on Libor?

The big question is, can the term auction facility do what the fed funds rate used to do, which is influence the Libor rate, or market-driven London interbank offered rate? Making Libor lower means making the economy's most meaningful interest rates lower. A lower Libor rate can unlock the current credit market seizure, bring down borrowing costs for financial institutions and possibly stem the tide of foreclosures and economic contraction.

Libor is the rate at which banks lend short-term money to each other. It is also the rate on which 100% of subprime mortgages are based and on which 60% of Alt-A adjustable rate mortgages are based, according to the New York Fed. Bringing down Libor means banks are not in hoarding mode, and people's mortgage resets will be lower -- both the ultimate goals of the Fed.

Typically, movements in the fed funds rate affect the Libor rate very closely, which historically runs about 10 basis points or so over the fed funds rate. Since July, when the credit market crisis began, the difference between Libor and the fed funds rate has grown, making each fed funds rate cut seem less effective. In July, when the fed funds rate was 5.25%, Libor was 5.35%.

Wednesday morning, the fund funds rate stood at 4.25%, and Libor remained at 5.11%. Libor fell 24 basis points for 100 points of fed funds easing. So each ease, or 25 basis points of fed funds cuts, meant just 6 basis points to Libor.

The market took Wednesday's liquidity announcement for more than double an ease, says Bianco. Tullett Prebon, a firm that allows traders to make bets where key rates will set the next day, shows traders believe Libor will fall to 4.975% to 4.98% Thursday morning.

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So, the Fed's Wednesday move is in many ways more of an ease than the ease. And the central bank does not have to risk further debasement of the dollar, which comes with the fed funds rate cuts, in order to solve the credit markets' problems.

But some market participants question whether Libor can really fall meaningfully until financial institutions find the floor of their balance sheet writedowns. Then banks like


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Merrill Lynch



Washington Mutual

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, among others, can get back to the business of lending and growing.

"Ultimately what solves the Libor problem is improvement in the ability to value risk and securities," writes Tony Crescenzi, a fixed-income strategist at Miller Tabak and contributor to

, sister site to

. That, he notes, depends on when the housing market turns around, or if the refinancing wave took place at lower interest rates, which would relieve consumers facing high rate resets.

Banks have been unwilling to lend to each other because of looming uncertainty surrounding the valuation of loans and securities tied to bad mortgage loans that are left on many banks and financial institutions' balance sheets.

Wednesday morning alone,

Bank of America

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CEO Kenneth Lewis said its writedowns for collateralized debt obligations will be larger than previously thought come fourth-quarter earnings. The firm last month estimated it would take pretax CDO writedowns of $3 billion. Wachovia likewise nearly doubled its estimate of the cash it will have to set aside to cushion against failing loans, taking it to $1 billion from earlier estimates of $500 million to $600 million.

The Fed's first $20 billion auction will take place Dec. 17, the second Dec. 20, and the last two in January, according to the Fed's statement. Details on the sizes of the last two auctions will be decided next month. The Fed also noted it may conduct additional auctions in subsequent months depending on the state of the markets.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click


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