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Commentary by Caroline Baum
Sept. 17 (Bloomberg) -- The Federal Reserve defied market expectations amid a Category 4 hurricane on Wall Street and widespread flooding on Main Street, holding its benchmark overnight rate at 2 percent.
Whether it turns out to be the right decision in the long run, it was the Fed's, not the market's, to make.
Before the Fed comes under attack -- it's already starting - - for being out of touch and causing Great Depression II, a review of recent history is in order.
It was only three months ago that the collective wisdom of the market anticipated a 75-basis-point increase in the Federal Reserve's benchmark rate by year-end. Inflation was heading higher, policy makers were talking tough, and unless the central bank atoned for the error of its ways and corrected the negative real interest rates, the U.S. was destined to repeat the 1970s.
By early September, expectations for rate increases had evaporated. Stasis, always an uncomfortable place for bond traders, was short-lived. The fed funds futures sashayed in the opposite direction.
As this week got under way, Lehman Brothers Holdings Inc. filed for bankruptcy, Merrill Lynch & Co. leapt into the arms of Bank of America Corp., and American International Group Inc. was scrounging for an emergency loan. The changing financial landscape changed expectations again.
Financial futures contracts were quick to price for a 25- basis-point rate cut at yesterday's meeting. Some economists called for a 50-basis-point reduction in the federal funds rate, which has been at 2 percent since the end of April. A few said the Fed couldn't wait for the meeting and had to cut immediately. The future was looking like 1929, not 1970.
Quantity, Not Price
Yesterday, with stock markets around the world tanking, AIG gasping for air, central banks pouring in liquidity to prevent interbank lending rates from rising further, the Fed demonstrated that it was not in the market-appeasement business.
Why lower the fed funds rate? Banks and a select group of non-banks can borrow at the Fed's come-one-come-all discount window at a cut-rate price of 2.25 percent. The quantity is unlimited. The quality of the securities that the Fed accepts as collateral has gone down. And price isn't the issue.
This is about the availability of credit, or, in this case, the lack thereof. The Fed is trying to address the private sector's tightening of credit with several ``enhancements'' to its alphabet soup of liquidity facilities.
Last weekend, the Fed announced it was expanding the range of collateral it will accept on overnight loans at the Primary Dealer Credit Facility (PDCF) to include equities and non- investment-grade debt, or junk by any other name. Previously, the collateral had to have an investment-grade rating.
More Better
The eligible collateral for the Term Securities Lending Facility (TSLF) was expanded from AAA-rated to investment-grade debt.
The Fed upped both the size and frequency of its TSLF auctions. It pumped a combined $120 billion into the money markets on Monday and Tuesday to address the spike in the interbank lending rates.
A reduction in the federal funds rate isn't going to convince stock market investors that financial companies have properly accounted for their losses. (It wouldn't have the impact, say, of the prospect of a Fed loan package for AIG.) It isn't going to help reduce inflation, which is running well above the Fed's comfort zone and still a concern to policy makers, according to the statement released at the conclusion of yesterday's meeting.
And it isn't going to boost the U.S. dollar, which has been rallying for two months.
Yield Curve Relief
The one thing it will do is ``steepen the yield curve,'' says Paul Kasriel, chief economist at the Northern Trust Co. in Chicago.
Before the Fed announcement, the two-year Treasury note was trading at 1.7 percent. With the funds rate at 2 percent, ``it's hard to make a profit no matter how much volume you do,'' Kasriel says.
And who knows? The drop in two-year note yields might have matched any cut in the funds rate, keeping that spread constant.
The good news is that intermediate and long-term Treasuries offer a positive spread over the funds rate. By borrowing from the Fed and buying risk-free Treasuries, banks ``can earn the spread, improve their profits and build capital,'' Kasriel says. Treasuries aren't subject to the same risk-based capital requirements as private securities.
The positively sloped yield curve provided a way out of the 1990s savings and loan crisis. And it will do the same this time around, too -- slow, arduous process that it is.
Sept. 17 (Bloomberg) -- Confidence in the global economy fell in September as financial turmoil deepened in the U.S., a survey of Bloomberg users on five continents showed.
The Bloomberg Professional Global Confidence Index fell to 11.3, from 14.1 in August. Confidence among U.S. respondents fell to 10.6 from 18.2, while the Western European measure was at 12.6 after 12.9. A reading below 50 indicates pessimism.
A yearlong credit squeeze culminated in the past two weeks with the bankruptcy of Lehman Brothers Holdings Inc. and the bailout out of Fannie Mae, Freddie Mac and American International Group Inc. Overnight borrowing costs soared as banks hoarded cash.
``We moved from Fannie and Freddie to Lehman to AIG, and even today, one question is: who is going to be next?'' said Simon Barry, an economist at Ulster Bank in Dublin, who participated in the survey. ``A lot of these risks haven't gone away.''
The MSCI index of global financial shares has declined 10 percent since early last week. The U.S. Federal Reserve yesterday said it would lend the country's biggest insurer, American International Group Inc., $85 billion to avert the worst financial collapse in history. A day earlier, Lehman Brothers filed for bankruptcy and Merrill Lynch & Co. agreed to be taken over by Bank of America Corp.
About 3,500 Bloomberg users from Tokyo to New York posted responses between Sept. 8 and Sept. 12 as investors absorbed U.S. Treasury Secretary Henry Paulson's decision to bail out Fannie Mae and Freddie Mac, the lenders which own or guarantee $12 trillion of U.S. mortgages.
Credit Losses
Banks worldwide have tallied more than $500 billion in losses and writedowns since credit markets seized up a year ago.
``We haven't experienced anything like this since 1929,'' Former European Central Bank chief economist Otmar Issing, 72, said in a Bloomberg Television interview yesterday. ``Global growth will slow and is already slowing. But overall, the risks have mostly been confined to a few industrialized countries.''
Bloomberg users increased expectations that lower oil prices will allow central bankers to pare interest rates as the economic outlook deteriorates. In Germany, the measure for central bank- rate expectations fell to 34.1 from 42.7, signaling respondents in Europe's biggest economy now anticipate that the European Central Bank may cut its key rate in the coming six months. The gauges also declined in the U.S., Japan, and the rest of the euro region.
The price of oil fell by a third since touching a record $147.27 in July and traded at $93.26 a barrel in New York at 10:42 a.m. Central European Time today.
Timing of Recovery
``For global business confidence to improve two things are needed: the U.S. housing market to bottom out and a sign that the financial turmoil is nearing an end,'' said Masamichi Adachi, a senior economist at JPMorgan Chase & Co. in Tokyo. ``That won't be until around the second quarter in 2009.''
The cost of borrowing in dollars overnight more than doubled yesterday as banks hoarded cash amid speculation more financial institutions will fail. The overnight dollar rate soared 333 basis points to 6.44 percent, its biggest jump, according to the British Bankers' Association.
The euro region and the Japanese economies both contracted in the second quarter, while the European Union says the U.K. will suffer a recession in the second half of the year. In the U.S., unemployment jumped to 6.1 percent in August, the highest in five years.
Respondents in Japan were the most pessimistic about the global outlook. Participants in Spain, which the EU says faces its first recession in 15 years, were the gloomiest about their economy, with a reading of 4.1, followed by the U.K. Participants in Brazil remained the most optimistic about their economy, at 58.2.
Sept. 17 (Bloomberg) -- Russia poured $44 billion into its three largest banks and halted stock trading for a second day in a bid to stem the most severe financial crisis since its devaluation and debt default a decade ago.
The Finance Ministry extended the repayment period on loans available to OAO Sberbank, VTB Group and OAO Gazprombank to three months from one week. The benchmark Micex stock index plunged as much as 10 percent, taking its three-day decline to 25 percent, and brokerage KIT Finance said it's in talks with investors to sell a stake after failing to meet some obligations.
Russia's markets are facing the biggest test since the government defaulted in 1998. The decade-long economic boom is fading, foreign investors have pulled at least $35 billion from the nation's stocks and bonds since the five-day war in Georgia last month, and the collapse this week of Lehman Brothers Holdings Inc. and American International Group Inc. prompted a flight from emerging markets.
``I will tell my clients today to continue to abstain from buying Russian assets'' until economic problems are solved, said Zina Psiola, who manages a $1 billion Russian equities fund at Clariden Leu AG in Zurich.
The cost of lending has soared to a record, with the MosPrime overnight rate reaching 11.1 percent today, deterring speculative bets in equities. Russian stocks have lost more than $425 billion in value since reaching an all-time high May 17.
`Effectively Closed'
``The bond market remains effectively closed and banks are reluctant to lend to one another,'' said Julian Rimmer, head of sales trading at UralSib Financial Corp. in London. ``The problems experienced by KIT Finance have heightened counterparty risk and reduced liquidity further.''
Moscow-based KIT today said it is seeking to sell a stake after failing to meet some financial obligations related to repurchase agreements.
``Every day Russia falls due to people not being able to meet margin calls,'' said Marina Akopian manager of the Hexam EMEA Absolute Return Fund in London.
The ruble has lost 4.8 percent against the dollar since Aug. 8, when Russia sent troops and warplanes into Georgia for a military campaign that led to the worst relations with NATO since the Cold War. Investors have pulled at least $35 billion out of the country since the war, according to BNP Paribas SA estimates.
Economic Woes
Oil production, the government's biggest source of revenue, and accelerating inflation are adding to concerns for investors. Crude output is falling for the first time since 1998 and the inflation rate advanced more than expected in August, to near a five year high of 15 percent.
Industrial output grew more slowly than economists expected in August and economic growth in the second quarter slowed to an annual 7.5 percent from 8.5 percent in the previous period.
Still, unlike 1998, Russia is ``pretty well prepared'' to weather the turmoil, the World Bank's chief representative in Russia, Klaus Rohland, said today. The economy has grown every year for a decade and its international reserves have surged in the period by almost 50 times to $574 billion, more than any other country except China and Japan.
The Finance Ministry yesterday's added $20 billion to the interbank lending market.
`Shock Changes'
Sberbank, VTB and Gazprombank ``are market-making banks capable of insuring the liquidity of the banking system,'' the ministry said in a statement today. The government and central bank will take more measures to improve liquidity this week, the ministry said.
Finance Minister Alexei Kudrin said the measures should ``smooth over the shock changes'' in the markets. ``With foreign borrowing stopping, we must soften the impact with additional funds, then the situation will stabilize,'' he said on state television.
The ruble-denominated Micex Stock Exchange suspended trading indefinitely at 12:10 p.m. after its index erased a 7.6 percent gain and plunged as much as 10 percent within an hour. The benchmark fell 17 percent yesterday, the biggest decline of the 88 indexes tracked by Bloomberg. The dollar-denominated RTS halted trading after similar declines.
Sberbank has fallen 32 percent and VTB Group 47 percent this week.
``The primary objective of these measures is to inject liquidity to calm nervousness,'' Alexander Morozov, chief economist at HSBC Bank in Moscow, said by telephone. ``Hopefully other banks will be able to get this money via the interbank market and this should prevent the rise of rates,'' he said.
Sept. 17 (Bloomberg) -- Islamic terrorists targeted the U.S. Embassy in Yemen's capital, Sana'a, blowing up a car outside the entrance to the compound and killing 16 people in the second attack against the mission in six months.
The death toll included six militants, four civilians and six soldiers guarding the embassy, the state-run Saba news service said, citing the Interior Ministry. The building wasn't damaged and staff in the mission were unhurt, Saba reported.
``At about 9:15 this morning a car exploded at the main gate of the embassy and then there was a secondary explosion,'' Ryan Gliha, a spokesman for the embassy, said in a phone interview.
A group by the name of Islamic Jihad claimed responsibility for the attack and threatened to carry out similar strikes in the Persian Gulf region if al-Qaeda prisoners aren't released by the Yemen, the al-Arabiya news channel said. Osama bin Laden's family originally came from the Yemen, and the country has served as a recruiting ground for al-Qaeda in the past.
The attack involved a first car from which attackers exchanged fire with embassy guards, using rocket-propelled grenades, and then a second bomb-laden car was blown up, Dubai, United Arab Emirates-based al-Arabiya said.
``I heard two loud explosions,'' said Christy Quirk, 40, a consultant who was located two miles from the embassy in the lobby of the Burj al-Salam hotel in the old city.
The fortified U.S. Embassy, located in the Dhahr Himyar area, lies about 250 meters (820 feet) from the entrance, where the attack took place. A fire was seen blazing from the compound and ambulances headed toward the area.
USS Cole Attack
The U.S. State Department ordered the withdrawal of non- emergency staff and family members from the embassy in April following an attack on March 18 and an April 6 assault on the Hadda residential compound in Sana'a. The measure was lifted on Aug. 11 and the State Department recommended deferring non- essential travel to the country.
Six children as well as Yemeni workers protecting the embassy were injured when the March 18 blast rocked a school close to the U.S. compound, Yemeni authorities said at the time.
In 2000, al-Qaeda terrorists attacked the USS Cole in Yemen in an incident that killed 17 sailors.
Sept. 17 (Bloomberg) -- American International Group Inc. fell 30 percent on speculation the government's takeover will ultimately wipe out shareholders.
AIG dropped $1.14 to $2.61 at 9:39 a.m. in New York Stock Exchange composite trading. The U.S. plan to save the New York- based company, the nation's largest insurer by assets, may give the government an 80 percent stake in return for an $85 billion loan, and dividends may be halted to common and preferred stockholders. They're already reeling from a 94 percent drop in the common shares this year.
The ``punitive'' interest rate on the two-year loan ``makes it extremely clear that this is not a subsidy extended to keep the company afloat but rather a stranglehold that makes AIG unviable while ensuring that its obligations will be met,'' said Marco Annunziata, an analyst at UniCredit SpA, in a note to clients. ``This is to all extents and purposes a controlled bankruptcy.''
AIG unraveled as the worst housing crisis since the Great Depression led to more than $18 billion of losses in the past year. A meltdown could have cost the financial industry $180 billion, according to RBC Capital Markets, because AIG provided insurance on more than $441 billion of fixed-income investments held by the world's biggest institutions, including $57.8 billion in securities tied to subprime mortgages.
The U.S. reversed its opposition to a bailout of AIG, after private efforts collapsed and the Federal Reserve concluded that ``a disorderly failure of AIG could add to already significant levels of financial market fragility,'' according to a Fed statement late yesterday.
`Systemic Risk'
``It's an enormous relief,'' said David Havens, credit analyst for UBS AG in Stamford, Connecticut. ``Nobody really knows what it would have meant if they would have been allowed to fail, but there was an enormous amount of systemic risk. The problem was, nobody really knew how bad it could have been.''
The agreement will give the company, which sells insurance in more than 130 countries, time to sell assets ``on an orderly basis,'' AIG said in a statement. Chief Executive Officer Robert Willumstad, 63, will be replaced by former Allstate Corp. CEO Edward Liddy, 62, according to a person familiar with the plans, who declined to be identified because the change hadn't been formally announced.
AIG's $2.5 billion of 5.85 percent notes due in 2018 jumped 8.25 cents to 53 cents on the dollar as of 9:29 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
The debt yields 15.6 percent, or about 12 percentage points more than similar-maturity Treasuries, Trace data show.
Credit Downgrades
The survival of the 89-year-old insurer fell into doubt when Standard & Poor's and Moody's Investors Service cut its credit ratings on Sept. 15. The reductions threatened to force AIG to post more than $13 billion in collateral when the company was already short on cash. AIG couldn't raise money by selling shares after the stock plunged to less than $4 a share from $70.11 in October of last year.
``There could be a greater need for capital'' beyond the $85 billion, New York Insurance Superintendent Eric Dinallo told CNBC today, adding that the loan will give AIG time to sell units.
The loan will ``be sufficient to handle AIG's collateral needs'' and allow the insurer to refinance debt as it comes due, said Wachovia Corp. analyst John Hall in a note today.
The Fed's loan doesn't require asset sales or the company's liquidation, though these are the most likely ways AIG will repay the Fed, central bank staff officials told reporters on condition of anonymity. Blackstone Group LP advised AIG on the transaction.
Markets Unprepared
The Fed doesn't have an expectation of whether AIG will be smaller, nonexistent or similar to its current form at the end of the loan's term, the staffers said.
The Fed or Treasury will end up holding the AIG stake, the staffers said. The Fed bailed out AIG while refusing aid to Lehman Brothers Holdings Inc., which collapsed earlier this week, because financial markets were more prepared for a Lehman failure, a Fed staff official said.
The Fed stepped in after JPMorgan Chase & Co. and Goldman Sachs Group Inc., which were brought in to help assess AIG, failed to come up with a solution, according to a person familiar with the talks. Liddy is currently on the board of Goldman, the company Henry Paulson ran as CEO before becoming the U.S. Treasury secretary in 2006.
Hank Greenberg
Willumstad, the former Citigroup Inc. president who left the bank in 2005 to seek a CEO position, was named to AIG's top post in June. His predecessor, Martin Sullivan, was chief for three years until being ousted after two record quarterly net losses. Maurice ``Hank'' Greenberg reigned at AIG for almost four decades until he was forced to retire in 2005 amid regulatory probes.
Greenberg, who remains one of the company's biggest stakeholders, said the company needed a bridge loan instead of a plan that put the company under government control. An investor group led by Greenberg said in a federal filing hours before the rescue was announced it might want to buy the company or some units or make loans to AIG.
``Why would you want to wipe out shareholders when you just need a bridge loan?'' Greenberg, 83, said in an interview before the announcement. ``It doesn't make any sense.'' Greenberg declined to comment after the Fed announcement, spokesman Glen Rochkind said.
Sept. 17 (Bloomberg) -- U.S. stocks tumbled after housing starts slid to a 17-year low and bank lending seized up in the wake of the government's takeover of American International Group Inc.
Investors fled the stock market to the relative safety of U.S. Treasuries, driving the yield on three-month bills to the lowest in 54 years. Morgan Stanley, the second-largest securities firm, tumbled 20 percent, General Electric Co., the world's third-biggest company, slid 6.1 percent and US Airways Group Inc. lost 7.4 percent.
``It's ugly,'' said Michael Mullaney, a Boston-based money manager for Fiduciary Trust Co., which oversees $10 billion in stocks and bonds. ``It's about the worst I've seen it in 25 years. You have to have free-flowing credit to lubricate the system. That's not happening right now.''
The Standard & Poor's 500 Index lost 27.83, or 2.3 percent, to 1,185.76 at 9:36 a.m. in New York. The Dow Jones Industrial Average decreased 220.97, or 2 percent, to 10,838.05. The Nasdaq Composite Index sank 39.35, or 1.8 percent, to 2,168.55. More than 10 stocks retreated for each that rose on the New York Stock Exchange.
European stocks erased earlier gains, while Chinese and Hong Kong equities declined. Russia halted stock trading for a second day and poured $44 billion into its three biggest banks in a bid to halt the biggest financial crisis since its devaluation and debt default a decade ago.
The three-month London interbank offered rate, or Libor, rose 19 basis points to 3.06 percent, the British Bankers' Association said.
TED Spread
U.S. Treasury three-month bill rates dropped to as low as 0.233 percent and the so-called TED spread, the difference between three-month Treasury yields and three-month Libor, widened widened 64 basis points.
AIG lost $1.30, or 35 percent, to $2.45. The insurer, which received the $85 billion loan from the U.S. government yesterday, is most likely to repay the loan by liquidating or selling assets, central bank staff officials told reporters on the condition of anonymity. The Fed will take 79.9 percent of the New York-based company's stock and replace its management because ``a disorderly failure of AIG could add to already significant levels of financial market fragility,'' according to a central bank statement yesterday.
Financial shares also fell after the Reserve Primary Fund, the oldest U.S. money-market fund, became the first in 14 years to expose investors to losses after writing off $785 million of debt issued by Lehman. Investor redemptions will be delayed as long as seven days, the fund said
Housing Slump
Hovnanian Enterprises Inc., New Jersey's largest homebuilder, slid more than 3 percent after the Commerce Department reported a 6.2 percent slump in home starts.
The S&P 500 gained 1.8 percent yesterday as expectations grew the Federal Reserve would rescue AIG and spare financial institutions from more losses.
The benchmark index for American equities started the week with a 4.7 percent tumble after credit losses forced Lehman Brothers Holdings Inc. to file for bankruptcy protection and Merrill Lynch & Co. to agree to be taken over by Bank of America Corp.
The S&P 500 has fallen 17 percent this year and is poised to post its first yearly retreat since 2002 after global banks racked up more than $514 billion in credit losses and asset writedowns stemming from the collapse of the subprime mortgage market.
Financial shares in the S&P 500 have lost 32 percent as a group this year, led by a 94 percent tumble in AIG, an 83 percent drop for Washington Mutual Inc. and a 76 percent retreat in National City Corp.
A gauge of homebuilders in S&P indexes is up 4.3 percent this year after the government's rescue of AIG and mortgage- finance companies Fannie Mae and Freddie Mac boosted optimism that the housing market will recover. All 15 companies in the index advanced yesterday, sending it to a 4 percent rally. The group lost 56 percent in 2007 amid the collapse of the subprime mortgage market.
The Federal Reserve kept its benchmark interest rate at 2 percent yesterday, citing risks to growth and inflation. Hours after yesterday's meeting, the central bank agreed to the AIG loan. in a statement.
Tuesday, September 16, 2008
What Price Stability?
by James A. Dorn
James A. Dorn is a China specialist at the Cato Institute and coeditor of China's Future: Constructive Partner or Emerging Threat?
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The US Treasury's takeover of Fannie Mae and Freddie Mac, the nation's largest mortgage financers, was predictable. The drive for profits while housing prices were rising, and the expectation that the federal government would not let these market-socialists fail, allowed Fannie and Freddie to accumulate a huge portfolio of mortgages and mortgage-backed securities. Now that the asset price bubble in housing is being deflated and Fannie and Freddie's capital is shrinking, the Fed is compelled to come to the rescue in order to "stabilise" US and global financial markets.
The real issue is: "what next?" The two government-sponsored enterprises (GSEs) are going to be allowed to continue to expand their portfolios until the end of next year, but will then have to begin trimming back by about 10 per cent per year. In the past, Fannie and Freddie showered large sums on members of Congress to win votes and retain their privileged position. Although those payments are now illegal, Fannie and Freddie have many friends on Capitol Hill who believe the GSEs are essential to affordable housing; they will fight hard to maintain the status quo.
Fundamentally, the Fannie and Freddie debacle is about the role of government in a free society. If government is limited to protecting people and property, and individuals are allowed to keep the fruits of their labour and to bear the risks of loss, then capital will be efficiently allocated.
The secret to a harmonious financial system is to get institutions and incentives right. Experience has shown that market liberalism best directs resources to where they have the most value to society. The so-called voluntary principle, based on private property and the rule of law, allows information to be effectively processed by those individuals who have a stake in the results. Effective private property rights mean that rewards and losses are concentrated on decision-makers, not taxpayers. The hybrid nature of GSEs - whereby profits flow to shareholders and managers while losses are socialised - distorts institutions and incentives, and misdirects capital. Congress then calls for more regulation and delegates power to some regulatory agency to oversee the GSEs. However, when regulators have little to gain from efficiency, and losses due to lax regulation accrue to taxpayers, what incentive is there to be prudent?
Preserving the status quo by maintaining Fannie and Freddie's crony capitalism would expand the size and scope of government, rather than make individuals responsible for their mistakes.
Fundamentally, the Fannie and Freddie debacle is about the role of government in a free society.
The problem is that once markets are polluted with privileged firms, private entrepreneurs will be crowded out. Instead of moving to a self-regulating market, the GSEs will be made to obey new regulations, which often have unintended consequences. The takeover of Fannie and Freddie could cost taxpayers US$200 billon to US$300 billion - and far more if housing prices fail to stabilise.
Once the door to government intervention is opened, more people and firms want favours. Keeping interest rates lower than market rates to benefit GSEs distorts capital markets. Contagion is often blamed on "market failure". In fact, if true private markets exist and the locus of responsibility is on individuals rather than being socialised, errors of judgment would not accumulate as they do under market socialism or crony capitalism.
The next administration and Congress will have to decide whether to shut down Fannie and Freddie or continue on the path of market socialism. Choosing the latter would mean more regulation and state control, and less freedom. It would change the distribution of risk but not reduce risk.
When the US Treasury is raided to defend the government's credibility to guarantee GSE debt, it may calm markets for a time. Yet, in the long run, the drifts towards socialism and increased government borrowing requirements discourage foreign investment, decrease private saving, increase interest rates and slow US growth. That is a high price to pay for "stability".
Sept. 17 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke is betting he can use targeted emergency loans rather than another interest-rate cut to pull Wall Street through the credit crisis.
The Fed kept the benchmark rate at 2 percent yesterday, citing risks to growth and inflation. Two days earlier, officials allowed securities firms use equities as loan collateral to ease the impact of Lehman Brothers Holdings Inc.'s bankruptcy. Hours after the meeting, the Fed agreed to an $85 billion loan as part of a government takeover of American International Group Inc.
By rebuffing calls by some investors for a rate cut, the central bank aims to meet its mandate to ensure stable prices while counting on auctions of cash and Treasuries and direct loans to address the credit crunch.
Policy makers believe ``lowering the funds rate is a blunt instrument and not aimed at financial markets,'' said Stuart Hoffman, chief U.S. economist at PNC Financial Services Group in Pittsburgh and a former Fed economist. Instead, officials are relying on ``creative and innovative ways to get funds into the financial system.''
At the same time, the Fed edged closer yesterday to a rate reduction by saying in a statement after their meeting that financial-market strains have ``increased significantly.''
Employment is weakening, export growth is slowing and risks to growth and inflation are ``both of significant concern,'' the central bank said in its statement. After their Aug. 5 meeting, policy makers said such concerns applied only to inflation. The central bank yesterday dropped a reference last month to rising expectations that prices will increase.
`Push the Committee'
``The outcome is going to be driven by the incoming data,'' former St. Louis Fed President William Poole said in an interview with Bloomberg Television. If retail sales, industrial production and employment are weak, ``that is going to push the committee probably to cut rates.''
Tumbling commodity prices, including a 37 percent decline in crude oil from a July 11 peak, ease pressure on the Fed to fight against inflation. The consumer price index fell 0.1 percent in August, the Labor Department said yesterday. So-called core prices, which exclude food and energy, rose 0.2 percent after a 0.3 percent gain in July.
The rout sparked by the collapse of the U.S. subprime mortgage market has cost financial institutions worldwide $516 billion in writedowns and losses since the start of 2007. Firms have raised $362 billion of capital in response.
Since the credit crisis began in August 2007, the Fed has lowered the rate on direct loans to commercial banks and created one loan program for banks and two for securities firms. It also secured the sale of Bear Stearns Cos. to JPMorgan Chase & Co. by taking on $29 billion of mortgage-backed debt and other assets.
AIG Takeover
Late yesterday, the Fed agreed to an $85 billion loan for AIG, the insurer hit by billions of dollars of writedowns on investments in securities tied to mortgages. The government will get a 79.9 percent equity interest in the company as a result.
Fed staff officials told reporters on a conference call that AIG's extensive operations across financial markets, including substantial business outside of insurance regulators' jurisdiction, meant the company needed rescuing.
``The Fed is reasonably confident that the fundamental and liquidity problems in the financial markets can be adequately addressed with the various tools they have at their disposal,'' said David Resler, chief economist at Nomura Securities International Inc., in New York. ``It doesn't require a shotgun approach to macroeconomic policy.''
Rate Cuts
New lending mechanisms and rate cuts totaling 3.25 percentage points in the past year have so far failed to revive lending among banks.
Central banks around the world pumped more than $210 billion into the financial system this week as they sought to alleviate the credit-market seizure.
The New York Fed injected $70 billion of temporary reserves into the banking system yesterday and $70 billion Sept. 15, the most since the September 2001 terrorist attacks. The central bank has also provided billions of dollars through direct loans of cash and Treasuries.
Still, banks are hoarding cash, driving up short-term lending rates.
The cost of borrowing in dollars overnight more than doubled to the highest since 2001. The overnight dollar rate soared 3.33 percentage points to 6.44 percent yesterday, its biggest jump in at least seven years, according to the British Bankers' Association. The rate was as low as 2.07 percent in June.
Economists anticipate the economy will slow to a 1.2 percent annual growth rate, or less than half the prior quarter's pace, as consumer spending, the biggest part of the economy, stalls this quarter, according to a Bloomberg survey this month.
``The financial-market turmoil we have seen has tightened financial conditions,'' Brian Sack, who used to serve as head of monetary and financial market analysis at the Fed and is now a vice president at Macroeconomic Advisers in Washington, said in a Bloomberg Radio interview. ``That is really going to impart some restraint on the economy.''
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