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Don’t count on Fed easing interest rates at first sign

By Rachel Beck
AP Business Writer

NEW YORK — Face it: Risk-taking doesn’t come with guarantees. That means no one should count on the Federal Reserve to bail us out of the current credit slump so fast.

As stock and bond markets swoon over worries about weakening debt, more investors seem to be thinking that the Fed will soon come to the rescue by lowering interest rates.

Difference in style

Investors may be getting ahead of themselves. There’s a new sheriff in town: Ben Bernanke. As long as the credit fallout doesn’t look like it is spilling over into a full-fledged economic collapse, his central bank might not be quick to meddle.

After boosting its overnight lending rate 17 times over the two years beginning in June 2004 to slow the economy sufficiently to hinder inflation, the Fed has left the rate unchanged since last summer at 5.25 percent.

Investors have been anxiously awaiting the central bank’s next move — and
hoping it’s a rate cut, given what’s happening in credit markets.

Once-plentiful liquidity is drying up now that the implosion in subprime mortgages has caused lenders all around to raise interest rates or ask for other protections to guard them against risk.

The deteriorating credit conditions have led to major hedge fund losses. Two Bear Stearns funds filed for bankruptcy court protection Tuesday after seeing their assets plunge in value.

In addition, dozens of mortgage lenders have gone out of business.

Debt investors

Debt investors, in turn, are fleeing risk, dumping junk bonds and other lower-quality securities and turning to the safer haven of government bonds.

Stocks have been battered by a punishing decline from new highs, with the Dow Jones industrial average tumbling more than 600 points since its record close above 14,000 on July 19.

With financial markets on edge, there is growing optimism that the Fed will ride in like the cavalry to the rescue. In the federal funds futures market — where speculators bet on future Fed actions — there is now a 95 percent probability for a rate cut by year-end, up from about 32 percent a week ago, according to Merrill Lynch.

Clearly, they are using history as their guide. As Goldman Sachs notes in a recent report, there have been two examples of “financial stress” spurring the Fed to ease rates in the last 20 years. The first came in 1987 after the October stock market crash, which saw major market indices plummet more than 20 percent in a single day.

Russia’s debt default

The next was in 1998, after Russia’s debt default in August of that year prompted investors to reassess their risk appetite. Credit spreads widened over the next weeks, which raised fears about an oncoming recession. That led to the failure of well-regarded hedge fund Long-Term Capital Management, which spurred worries about stress on the financial system.

But Alan Greenspan led the Fed back then. Today’s chairman is Bernanke, who isn’t expected to “play the game of riding to the rescue of the markets like Greenspan did,” said Milton Ezrati, senior economic and market strategist at money management firm Lord, Abbett & Co. “He will be more judicious in cutting rates.”

Action by Fed

The Fed won’t likely ease unless there is evidence that the credit crisis is causing consumer spending and employment to significantly weaken. So far, that hasn’t happened; the Conference Board reported Tuesday that consumer confidence hit a six-year high in July, and more respondents said jobs were “plentiful” than in June, and fewer said that jobs were “hard to get.”

In addition, Bernanke has been very clear in saying that the Fed wants to steer clear from doing anything that rattles inflation expectations. In a speech last month, he stressed how sensitive actual inflation is to people’s expectations about future inflation, Ezrati said.

That’s why the Fed may not rush to move rates: It could potentially boost pricing pressures by reducing the cost of borrowing and hurting an already weak U.S. dollar. Core consumer inflation is already nearing the Fed’s ceiling of 2 percent.

No doubt that the Fed is carefully watching for any signs that credit woes are spreading and intensifying. But right now they seem to think that what has been going on is a normal shakeout of an overextended credit market, where loans were made to borrowers who shouldn’t have gotten them.

“Most of these upsets stabilize on their own, but some do not. I’m not saying that the Fed should ignore what happened last week — we need to understand what is happening,” William Poole, governor of the St. Louis Fed, said in a speech Tuesday. “However, it is important that the Fed not permit uncertainty over policy to add to the existing uncertainty. The market understands, I believe, that the Fed will act in due time, if and when evidence accumulates that action would be appropriate.”

Measuring danger

Still, what’s tricky for Bernanke’s Fed is how to measure risk. Today’s market is filled with all sorts of new derivative products that were created by slicing and dicing up risk and repackaging it for sale.

“It is unclear where all the risk is in today’s market,” said Gus Faucher, director of macroeconomics at Moody’s Economy.com Inc. “And we aren’t sure how it will function when hit with a big problem.”

The Fed has an obligation to help financial markets when they are in need. It just gets to decide when that time of need has come.

Rachel Beck is the national business columnist.

Copyright 2005 Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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