Watch What They Do, Not What They Say

GIVE PROFESSOR BERNANKE A B-PLUS for substance and a C-minus for his communication skills.

The Federal Reserve kept its innovative scheme to inject liquidity where it's most needed under wraps when it announced its cuts in key interest rates Tuesday, which resulted in a steep, 300-point plunge in the Dow Jones Industrial Average.

The official explanation was that the Fed didn't want to announce the new plan until European markets were open. The nosedive in stocks Tuesday following the announcement of the Federal Open Market Committee's decision to lower its federal-funds target by 25 basis points, with a matching cut in the discount rate, had nothing to do with the unveiling of the new credit facility Wednesday.

That's their story, and they're sticking to it. But Fed officials did get on the horn Tuesday night to get the word out there was more to come after watching the swan dive in stocks following the FOMC announcement.

When the Fed and other central banks officially announced their liquidity-provision plan Wednesday morning, the Dow initially shot up 200 points. But David Goldman of Astari Capital wagered a drink that the market would wind up lower, and stocks were flashing red by the final hour, but the Dow managed to end up a meager 40-odd points in the green by the end.

Indeed, the botched announcement of the Fed's plan to auction loans may have effectively offset the liquidity the central banks sought to provide, Goldman says. The wild gyrations in the market effectively result in trading desks' and hedge funds' pulling in their horns, reducing credit availability by roughly the same amount the central banks might provide, he explains.

What's done is done. So what about the new Fed scheme? It may not be the magic bullet to cure the credit crisis, but it's a far sight better than the blunderbuss approach taken in recent years.

Essentially, the Fed has set up an eBay for credit for banks and other depository institutions. Borrowing from the Fed's discount window used to be like going to the pawn shop. You'd hope your neighbors never saw you there and found out you were strapped for dough.

As a result, borrowing from the discount window has lagged despite the Fed's efforts to remove its stigma. But auctioning off your stuff online gets you needed cash anonymously and nobody's any the wiser.

That's how the Fed's Term Auction Facility is supposed to work. Monday, the first auction of $20 billion in 28-day loans will take place, followed by a similar auction Thursday, Dec. 20. Those loans would help tide winning borrowers over New Year's, when private lenders have been reluctant to extend credit.

This plan addresses the key problem in the money and financial markets: money for terms longer than one day has been tight and expensive. The Fed can lower the overnight fed funds rate but money for a month or two or three -- the real benchmark for private borrowing -- remains dear.

How effective will it be? Merrill Lynch chief North American economist David Rosenberg says the $40 billion provided by the first two Fed auctions amounts to a proverbial drop in the bucket of credit losses faced by banks and other financial institutions.

The effect, adds Paul Kasriel, chief U.S. economist at Northern Trust Co., is for the Fed to provide more reserves to the banking system through this facility and commensurately less through open-market operations.

A hint of that came when the Fed let $5 billion of Treasury bills in its portfolio mature Thursday, which effectively drains reserves. Clearly, the Fed knew that it would be providing reserves in another matter, even if we didn't.

In any case, the Fed's new scheme contrasts with the blunt approach used by former Fed Chairman Alan Greenspan, and is more in keeping with the tack utilized by his predecessor, Paul Volcker.

Where Greenspan instituted a prolonged period of preternaturally low interest rates to counter perceived threats from deflation and resulting debt problems in the early years of this decade, Volcker did the opposite. In the Continental Illinois crisis of 1984, the Fed funneled reserves into the troubled bank and, importantly, drained them from the rest of the system. Thus, the liquidity provision benefited only those that needed it.

A sharp drop in the funds rate, such as the one engineered by Greenspan in 2001-03, would mainly reward speculative players. Indeed, Sir Alan continues to insist that 1% short-term rates can't be blamed for the excesses in mortgage credit that followed. But providing excessive incentives inevitably creates distortions, and cheap money surely distorted the housing market.

The Bernanke approach seeks to alleviate strains where they are most acute rather than dropping money from helicopters (a metaphor pinned on the Fed chairman though originated by Milton Friedman, the late, great monetary economist.)

Will it work? Eurodollar futures rallied, though bank stocks didn't, after details of the new credit-provision plan came to light. Banks face continued writedowns, which will constrain their ability to provide credit. The rest of the financial system, which has all but superseded banks as sources of credit, remains dependent on being able to fund their liabilities efficiently and cheaply.

Bernanke & Co. are attacking the problem with new, innovative weapons. Will they work? That's an open question.

But if you're wishing the Fed can turn around and twirl a magic wand to make everything OK, you're apt to be disappointed.