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Real Rout Greets Faux Ease

The 'effective' fed funds rate is below 5.25%, but stocks are falling at an accelerating pace.


Federal Reserve

is playing a tricky hand as calls for an emergency rate cut get louder after another day of significant stock market losses. Through its open market activities, the Fed has virtually cut the fed funds rate already, but officially left the target rate steady at 5.25%.

"The target funds rate is meaningless for the time being," says James Bianco, president of Bianco Research.

The Fed has injected enough liquidity into the banking system to bring the effective fed funds rate, or the rate that banks lend to each other, below 5% for three days now. This average overnight lending rate impacts the fed funds futures market, which now puts 40% odds on a 50-basis point rate cut by the Federal Open Market Committee's Sept. 18 meeting, according to Miller Tabak.

By allowing lending at a rate lower than the target, the central bank demonstrates its willingness to grease the panicky markets with extra cash in difficult times. But the steadfastness on the formal target rate says the Fed still believes the credit dislocations are a temporary problem, and that they won't impact the economy's strength.

Traders were sending another message Wednesday as another late-day selloff sent majors averages reeling. After trading near break-even for much of the day, the

Dow Jones Industrial Average

closed down 1.3% at 12,861.47, closing below 13,000 for the first time since late April. The

S&P 500

fell 1.4% or 19.8 points to close at 1406.70, and the

Nasdaq Composite

fell 1.6%, or 40 points, to close at 2458.83.

When markets are not so volatile, the rate that banks lend to each other matches the fed funds target rate, currently 5.25%. If it bank-to-bank lending rates waver even mildly from the target, the Fed typically defends that rate by adding or removing liquidity. The average overnight Fed repo, or liquidity provision, is about $6 billion. On Wednesday, the Fed offered up $7 billion, much smaller than recent injections of $38 billion Friday and $24 billion last Thursday.

At some point, the Fed could come in and use open market operations to take liquidity away as quickly as it offered it up. If this credit crisis subsides and the economy keeps growing at a stable pace, the Fed would likely do just that. If this is the outcome, the Fed will have provided relief without having committed to a lower fed funds target rate.

The Fed is still loath to cut the target rate because data still support the notion that the economy is still strong. Wednesday's consumer price index report was benign, but capacity utilization and industrial production were strong, and the New York regional report on manufacturing activity was better than expected.

Deutsche Bank economist Joe Lavorgna writes that only a systemic financial crisis or economic damage would cause the Fed to cut. "In 1998, the economy did not have any lasting damage from the Long Term Capital Management crisis, as real GDP growth rose over 6% in the fourth quarter," he writes. "It is still possible that the economy can emerge from the current financial market funk relatively unscathed."

But as anxiety about the credit markets seeps into so-called safe asset classes like

commercial paper, the risk of contagion and economic collateral damage only grows.

Raw nerves continue to inspire large swings in the stock market on headlines like Wednesday's that mortgage lender

Countrywide Financial's


may face bankruptcy, according to a Merrill Lynch analyst.

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Countrywide Financial fell 13.3% Wednesday, as fears that a widening liquidity crisis would hamper the company's ability to fund its lending operations. Late in the day, traders said Countrywide's debt was trading lower as well.

By contrast,

Thornburg Mortgage


, which plunged 47% Tuesday, gained back 39% Wednesday when its president and chief operating officer Larry Goldstone said the company "will survive this disruption" in an interview on


"There is further evidence that troubles in the credit market persist and are perhaps worsening," says Mike Malone, trading analyst at Cowen & Co. "But you also have equities at attractive valuations with the S&P 500 trading at about 14 times earnings. ... That's why you have these swings in the market."

Malone admits that many stocks seeing rapid gains are the result of short-covering rallies, and "longer-term money is moving defensively into health care, consumer staples, and energy sectors," he says.

Indeed, the S&P's winners Wednesday included names such as





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Johnson & Johnson

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, although energy stocks slipped despite rising crude prices.

Other late-day credit market disruptions show the crisis continues. Three- and sixth-month Treasury bond yields plunged, bringing the yield on three-month securities below 4% in a rapid flight-to-quality trade. Also, spreads in the derivatives index tracking the leveraged loan market widened.

At the end of another rough day on Wall Street, cries for a an actual Fed rate cut are rising as many agree with Cowen's Malone, who says: "Liquidity isn't enough."

Call them commitment-phobes, but if recent history is any clue, the Ben Bernanke-led Fed is probably going to reject that notion for as long as it can.

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


to send her an email.