Sunday, March 23, 2008

Fed chairman tosses out the rulebook

Fed chairman tosses out the rulebook

By Craig Torres
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Federal Reserve chairman Ben Bernanke is being forced to throw out four decades of monetary history as the US financial system chokes on miscalculated risks and a deepening recession.

When Bernanke and his four Fed governors voted to become creditors to Bear Stearns they invoked a law that hasn’t been used since the 1960s.

Three days earlier, the Fed said it would lend as much as US$200 billion ($245.5 billion) by swapping Treasury notes on its balance sheet for high-risk privately issued mortgage-backed securities held by Wall St firms.

"It’s a redrawing of the relationship of the Federal Reserve with the rest of the financial system," said Vincent Reinhart, former director of the Division of Monetary Affairs at the Fed.

The risk of a so-called "moral hazard", where firms come to count on bailouts by a federal agency, "are considerable", he said.

But the cost of doing nothing may have been even greater, say other former Fed officials. Bernanke is attempting to keep the nation’s financial machinery working as record mortgage foreclosures make investors reluctant to hold even bonds backed by Government-chartered firms such as Fannie Mae and Freddie Mac. The 54-year-old Fed chairman is also trying to contend with a rapidly worsening economic slump. "As a Governor, you never want to be placed in this position," said former Fed Governor Laurence Meyer, who served during the central bank’s coordination of the rescue of hedge funds in 1998. "Everybody has to be uncomfortable with this. But ... just imagine what would have happened today if this action hadn’t been taken."

But some economists say the Fed may encourage risky behaviour. Willem Buiter, a London School of Economics professor and former Bank of England policymaker, called the Fed’s move "socialism for the rich, which is both inefficient and morally objectionable".

"There is no doubt the Fed has been nervous about extending its lending reach beyond banks that have a role in the payment system," said Marvin Goodfriend, a former senior policy adviser at the Richmond Federal Reserve Bank and now an economics professor at Carnegie Mellon University in Pittsburgh.

"Is the credit crisis so bad that it requires a breach of longstanding conventions?"

Former Treasury Secretary Lawrence Summers argues the Fed is trying to navigate through a once-in-a-generation financial and economic storm. Panic selling is lowering the value of stocks and bonds. Unemployment is rising, reducing incomes and spending, and falling asset prices - including homes - are leading to a contraction in credit. "That three-way combination feels like something we have not seen in this country in a very, very long time," Summers said.

Fed officials meet to set interest rates on Tuesday (US time). Futures traders are tipping a 50 per cent chance of 1 percentage point cut. A reduction of that magnitude would be the first in the two decades since the federal funds rate has been used to steer the economy.

"The name of the game is preventing disaster," said NYU economist Mark Gertler. "By letting one house burn down, you might have the whole neighbourhood burn down. You want to avoid that."

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