Monday, August 13, 2007

Gaining Some Perspective on the Fed’s Position

Two articles in the WSJ describe some of the issues the Fed and other central banks face in the current market. The first article addresses the markets for the last week or so and does a comparison to the 1998 financial crisis. Some limited excerpts below:

As an academic, Federal Reserve Chairman Ben Bernanke studied the policy mistakes that led to the Great Depression and the ways dislocations in financial markets can affect the rest of the economy.

Amid strained credit markets and a volatile stock market, the Fed, the European Central Bank and their counterparts in other parts of the world last week pumped billions of dollars and euros into money markets to keep short-term interest rates from rising as demand for short-term funds overwhelmed the supply. It was the biggest such maneuver since the Sept. 11, 2001, terrorist attacks.

For its part, the Bush administration declined to lift regulatory limits on mortgage giants Fannie Mae and Freddie Mac to allow them to buy more mortgages. President Bush and Treasury Secretary Henry Paulson instead sought to bolster confidence, a key commodity at times like this, by emphasizing the fundamental strength of the global economy.

How Mr. Bernanke and authorities around the world respond in the days ahead will affect whether the crisis passes without lasting damage or deepens to the point where the Fed and other central banks set aside anxieties about inflation and reluctance to appear to be bailing out investors who made bad bets.

The second article discusses the moral hazard of lowering rates. This article also gives some historical comparisons and to help gain some perspective on the current situation.

Wall Street has a dream: that the Federal Reserve will rescue financial markets with a sharp cut in interest rates.

Behind that dream lurks a problem, something financial people call moral hazard.

Moral hazard is an old economic concept with its roots in the insurance business. The idea goes like this: If you protect someone too well against an unwanted outcome, that person may behave recklessly. Someone who buys extensive liability insurance for his car may drive too fast because he feels financially protected.

These days, investors and economists use the term to refer to the market's longing for Federal Reserve interest-rate cuts. If investors believe the Fed will rescue them from their excesses, people will take greater risks and, ultimately, suffer greater consequences. Some grumble that the Fed created problems this way in 1998, 1999 and 2003.

But if the Fed were to ride to the rescue, the skeptics worry, it would encourage people to speculate even more, creating an even bigger bubble later.

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