The Fed announced yesterday that it would begin conducting a series of funds auctions to increase liquidity in the financial system. It also said that it would be conducting a series of currency swaps with the European Central Bank and the Swiss National Bank. (http://www.federalreserve.gov/newsevents/press/monetary/20071212a.htm)
Initial stock market reaction to the announcement was quite positive, especially coming off of the market’s disappointment with the 25 basis point cut in the federal funds rate on Tuesday. The language of the accompanying statement didn’t do much to sooth investors, either. (http://www.federalreserve.gov/newsevents/press/monetary/20071211a.htm)
But, as yesterday wore on, it seemed that investors had a change of heart. Why? The Fed’s actions won’t likely do all that much to deal with the problems in the short term credit market which are caused by the underlying problems in the mortgage and housing markets.
By auctioning off funds, the Fed said that it wanted to increase liquidity in the banking system. This is part of a continuing effort that began in August. Yet, repeated actions of the Fed (and other central banks) don’t seem to have done much to calm investor’s fears. What are folks afraid of? They don’t know how bad the mortgage problems are, how bad the problems with eventually get, and which financial companies are going to get whacked and by how much.
The fear can be seen in the spread of the labor rate over the federal funds rate and the 3-month T-bill rate. It’s huge, as documented in a Bloomberg article.
(http://www.bloomberg.com/apps/news?pid=20601087&sid=au0j7cvkiVno&refer=home). Banks are reluctant to lend to each other because no one is sure who has how much bad debt hidden away in a structured investment vehicle (SIV). The Fed’s actions don’t do much to allay these (reasonable) fears.
Also, will the auctions represent new liquidity, or will the Fed compensate by lowering liquidity with open market operations to prevent the federal funds rate from falling below the 4.25% target?
And: As long as home prices keep falling and interest rates on ARMs keep resetting upwards, the housing/mortgage problems will not go away. Short of reflating the housing market, the Fed’s actions are likely to have a modest impact. Though, it is not clear where we’d be if the Fed hadn’t done anything. In that case, it is likely that lack of any action on the part of the Fed would severely affect investor psychology, driving down asset prices even more.
On potential upside is this: To qualify to bid on the funds, financial institutions have to be certified as healthy (the auctions are not intended as bailouts) by the district Fed bank. So, banks, whether or not they need the money, may try to place winning bids to signal that they are credit worthy enough for other banks to deal with. This may be a small step in restoring bank to bank lending.
