FOMC Continues to Play Whack-a-Mole

In its continuing game of whack-a-mole, the Federal Open Market Committee acted in concert of five other central banks to lower interest rates, in the case of the FOMC, the target Federal Funds rate -- the rate banks charge each other for overnight loans -- was reduced to 1.50%, the lowest since August 2004.

With actions by the Federal Reserve and other government agencies coming fast and furious since Congress approved the Economic Emergency Stabilization Act (aka: $700 billion bailout) a week ago (yes, only a week ago), it may be worth it to step back and look at just what has been done, and why.

We also have to be wary of unintended consequences such as those that followed when the Treasury Department on Sept. 19 announced a temporary guaranty program for the U.S. money-market mutual fund industry. The U.S. Treasury said it would insure, for a year, the holdings of any publicly offered eligible money-market mutual fund -- both retail and institutional -- provided the fund pays a fee to participate in the program.

Community bankers panicked at the Treasury guarantee. The unintended consequence they realized -- but apparently Treasury didn’t -- would be a run on traditional bank deposits that offer a lower yield than money market funds. After some hurried conversations, Treasury modified the guarantees in an announcement 10 days later, saying the guarantee would apply only to funds on deposit as of the close of business on Sept. 19, 2008.

Here though is what the Fed has done in just the last two weeks:

September 22: Approved the applications of Morgan Stanley (MS) and Goldman Sachs (GS) to become bank holding companies and issued a policy statement on equity investments in banks and bank holding companies. As a result of the Fed action, Morgan Stanley and Goldman Sachs got the ability to borrow directly from the Fed and obtain funds through deposits, two low cost sources of fund.

September 24: Increased “swap lines” with the Reserve Bank of Australia and central banks in Denmark, Norway and Sweden to $277 billion to help support the dollar and provide additional liquidity (cash) for banks through the end of January.

September 26: Announced the Bank of England, European Central Bank and Swiss National Bank acted together to inject dollars into the overnight markets, increasing swap facilities by another $13 billion addition to $290 billion through the end of January.

September 29:  Increased those same swap lines (as well as those with central banks in Canada, England, Japan, Switzerland and the European Central Bank to a total of $620 billion, from $290 billion. The Fed said the actions “should reassure financial market participants that financing will be available against good collateral” and reduce concerns about funding when loans come due.

September 29: Reduced reserve requirements for banks by $1 million, thus slowing banks to keep less cash on hand and extended reporting requirements so that banks don’t have to check in with the Fed as often. 

On Oct. 3, the FDIC implemented temporary provisions of the bailout bill to increase to $250,000 from $100,000 the FDIC insurance limit for one account holder at one bank. 

October 6: Announced it would pay interest on the amount banks kept on reserve, even required reserves. The interest rates (differing for “required” and “excess” reserve) were set to be lower than the target Fed Funds rate to discourage banks from hoarding cash and to encourage them to lend to others. According to Fox Business’ Tracy Byrnes, in her book “Break Down Your Money Markets,” one way to think of the target Fed Funds rate is through its initials. The Fed Funds rate, she writes is “FF” as in friend to friend, bank to bank. The other form of Fed lending, direct to banks is through its discount window which she said is like “kids borrowing from ‘Dad.’” 

October 7:  Created the Commercial Paper Funding Facility to provide financing to issuers of commercial paper – short-term corporate borrowing. While the Fed had previously broadened its collateral requirements to allow banks to themselves borrow by using commercial paper as collateral, the Fed’s step in effect removed the middle man. But by doing so, banks would not receive the interest income from the loans.

“The commercial paper market,” the Fed explained, “has been under considerable strain in recent weeks” with the result that issuers who rely on the cash for payrolls or to purchase raw materials or inventories were squeezed. 

October 8: Lowered the Fed Funds rate. 

The cumulative effect of the actions, all designed to improve liquidity -- the availability of cash -- don’t necessarily address the underlying credit issues: that lenders don’t trust borrowers. 

Indeed, the “unintended consequence” of dribbling out new initiatives or expanding existing programs only reinforces a lack of confidence, giving the impression the Fed and others attempting to steer the economy through choppy waters don’t know which way to turn the wheel.

Mark Lieberman is the senior economist for the Fox Business Network. Prior to joining FOX, he served as first vice president and manager of economic analysis and research at Washington Mutual in New York. Before that, he served as senior vice president at Dime Savings Bank of New York (which was later acquired by Washington Mutual), where he specialized in credit and risk management. He is a member of the Executive Committee of the New York Association for Business Economics. He has a degree in Economics from the Wharton School of the University of Pennsylvania.