Fed Loads Cutlery into the Cannons

In a ‘historic’ move, the Fed slashes the Fed Funds rate 75bp. The new rate is only 25bp. Basically, zero interest rates.

My opinion … this is no big deal.

See my interview on BNN on this news.

However, the effective rate was already close to zero. So what if the official rate is now 25bp. There is no real difference. What the market cares about is the effective rate.

However, there are four other aspects of the Fed announcement that we should take note of.

First, Chairman Bernanke is using the November 21, 2002 playbook. This refers to a speech that he made as governor where he described what the Fed would do if faced with deflation and near zero interest rates.

Second, the December 16, 2008 Fed statement makes it clear that the Fed Funds rate will remain low for “some time”. This is an important commitment and serves to lower medium-term rates not just short-term rates.

Third, the Fed statement makes specific reference about the Fed buying longer-term Treasuries. This will reduce long-term rates and presumably reduce mortgage rates.

Fourth, and perhaps most importantly, the Fed says it will consider other options:

The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.” To me, this suggests that they are considering extraordinary moves such as purchasing other types of securities, such as CMBS, Asset Backed Securities, and perhaps corporate debt.

To play in the credit arena is not straightforward to do given that the Fed is not allowed by law to hold credit. However, the Fed has been very innovative in the past. For example, they set up a Special Purpose Vehicle to hold Commercial paper. It seems like a small jump to other types of credit.

The bottom line. We cannot rely on the policy makers or Treasury. The Fed has clearly taken the lead. They will do what it takes. My opinion we cannot regenerate the credit system until the toxic assets are expunged from the balance sheets of financial institutions. ‘What it takes’ involves picking up where the Treasury failed with its TARP.

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One Response to Fed Loads Cutlery into the Cannons

  1. Shailesh Kejariwal says:

    Agree with most of the points. However, Fed is forced to take credit on its book at this point of time. We cannot have a situation where there are bo buyers for any kind of credit. Hopefully, some confidence will be restored and more players will put their hand up and buy non government credit. The world requires US to bounce back.

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