Thursday, December 13, 2007

Fed Has Two Goals for Economy Obtain Moderate Growth and Easing the Strain on the Credit Markets

The Fed has gone down two separate tracks with their current money policy. The purpose of the Fed Funds rate cuts is to obtain moderate growth in the economy. The coordinated efforts with other central banks for injecting cash into the credit markets is to take some of the strain off the credit markets.

I am not sure if the latter move for the credit markets will work. The issue is not liquidity, but trust. One way a banker looks at his profit for other to other banks, especially if mortgage related securities are taken as collateral is by using risk adjusted margin (RAM):

RAM = Revenue – cost of funds – losses

To a banker the cost of funds is a fixed cost. Therefore, the only way to increase your RAM is to minimize losses or increase revenues. So you bump your interest rates (revenue to you) on your loans to other banks to compensate for higher than expected losses.

The central banks are trying to increase liquidity in the credit markets by lowering the cost of funds, but this does not effect their fear losses, so the market remain stuck. Text in bold is my emphasis. From Bloomberg:

The Federal Reserve's coordinated response to the global credit crisis is aimed more at easing strains in financial markets than at averting an economic slump.

The Fed, along with central banks in Europe, pledged yesterday to offer as much as $64 billion to financial institutions. The joint action is designed to break a logjam in money markets that pushed up borrowing costs for lenders worldwide.

Fed officials told reporters that they view yesterday's intervention as distinct from their interest-rate policy, which they anticipate will promote ``moderate'' growth next year. By attempting to keep the two tracks separate, economists said, policy makers are gambling that they will be able to avert a recession that would force them into deeper rate cuts than would otherwise be the case.

While ``this is a positive step for central banks to address the liquidity issues in the markets,'' said Richard Berner, the chief U.S. economist at Morgan Stanley in New York, ``it doesn't change my view of where the economy is headed.'' . . . .

. . . . .The Fed plans two auctions of funds to banks this month, totaling up to $40 billion. The step is in addition to the daily injection of money to bond dealers through repurchase agreements, and the backstop of direct loans to banks.

U.S. central bankers also will make as much as $20 billion available to the European Central Bank and $4 billion to the Swiss National Bank to ease demand for dollars among banks in Europe.

Fed officials discussed setting up auctions of so-called term funds in September as credit markets deteriorated. After the Sept. 18 half-point rate cut, bank funding costs receded and policy makers shelved the idea. When strains reemerged in November, the Fed looked again at the possibility.

U.S. and European officials then discussed steps to reduce bank funding costs when they met Nov. 17-18 near Cape Town in a gathering of the Group of 20, a Bank of England spokesman said yesterday. U.K. central bank Governor Mervyn King and his counterparts intensified their exchanges last week, he said.

Vice Chairman Donald Kohn and other officials said last month they were frustrated that three reductions in the discount rate hadn't encouraged banks to make more use of direct loans. Kohn said Nov. 28 in New York the Fed needed to ``give some thought'' to how it provided liquidity.

The Fed will also hold two auctions of term funds in January, deciding later whether to make them permanent.

``It's the right kind of thing, but I don't know if it's large enough or properly directed to make a difference,'' said Jerry Webman, head of fixed income in New York at OppenheimerFunds Inc., which manages about $220 billion. ``Money just isn't moving. Banks don't appear to be able to get a hold of reasonably priced funding.''

The three-month dollar London Interbank Offered Rate, a benchmark for borrowing, climbed as high as 5.15 percent last week from 4.87 percent a month before. The rate dropped to 5.06 percent yesterday.

Odds of further rate cuts rose. The chance of a quarter-point reduction of the benchmark rate to 4 percent at the Jan. 29-30 meeting reached 98 percent, from 94 percent Dec. 11, according to futures quoted on the Chicago Board of Trade.

Yesterday's step is ``not a game changer,'' said Tony Crescenzi, chief bond market strategist at Miller Tabak & Co. LLC in New York. ``It is an inadequate tool for dealing with the economy.''
Fed officials said in their Dec. 11 statement that the total of 1 percentage point of cuts to the benchmark rate ``should help promote moderate growth over time.'' They cited ``uncertainty'' about the outlook for both growth and inflation.

Separating yesterday's announcement with the Dec. 11 policy statement ``highlights how much they don't want to be seen as easing monetary policy,'' said Vincent Reinhart, former head of the Fed's monetary affairs division and now a resident scholar at the American Enterprise Institute in Washington.

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