Fed's strategy of boosting liquidity survives another day


By Craig Torres
Bloomberg News Service
Wednesday, August 22, 2007


The Federal Reserve's strategy of increasing liquidity rather than resorting to a cut in the benchmark interest rate survived a third day.

Yields on Treasury bills rose yesterday after the New York Fed lowered the cost of borrowing securities from its own portfolio to ease a shortage in the market. The action followed a reduction in the Fed's rate on direct loans to banks on Aug. 17, the impact of which officials said they need time to assess.

Chairman Ben S. Bernanke wants to avoid an emergency easing of monetary policy, contrasting with predecessor Alan Greenspan, who cut the federal funds rate target three times in 1998 after the collapse of Long Term Capital Management LP. Richmond Fed Bank President Jeffrey Lacker said yesterday that policy must be guided by the outlook for economic growth and prices, not entirely by markets.

"We did use the fed funds rate and that may have been a mistake," said former Fed Vice Chairman Alice Rivlin, who voted for the 1998 rate cuts. "It might have been smarter to try what they are trying."

Lacker said in a speech to a conference in Charlotte, North Carolina, yesterday that while the credit crunch and gyrations in financial markets have the potential to hurt growth, signs so far indicate business and consumer spending will continue.

In response to a question, Lacker also underscored the Federal Open Market Committee's determination not to insure poor investments with a cut in the federal funds rate. Ten-year U.S. Treasury notes fell in response, pushing the yield up 7 basis points to 4.66 percent at 9:45 a.m. in New York.

"The Federal Reserve isn't responsible for the size of credit spreads," he said. "We leave those to be market-determined. Our responsibility and what we are capable of influencing on a sustained basis is inflation and growth."

Some financial markets offer encouraging signs to policy makers. The Standard & Poor's 500 stock index has held the gains posted on Aug. 17, when the benchmark had its biggest one-day jump in four years. Lenders are also starting to write more "jumbo" mortgages as the market for loans above $417,000 improves, Treasury Secretary Henry Paulson said yesterday.

"When we look at the markets over the last couple of days, I've been encouraged to see signs that there's more liquidity in the jumbo" mortgage market, Paulson said in an interview with CNBC. "We're looking at all the markets, and you know, obviously, the equity markets, the sovereign-debt markets, the high quality credit markets, are all fully operational."

After the rate cuts in 1998, the economy strengthened and stock prices soared, Rivlin noted, leaving the Fed open to criticism that the reductions were a mistake. Rivlin is now director of the economic studies program at the Brookings Institution in Washington.

The Fed's current strategy showed some signs of success yesterday as yields on three-month Treasury bills climbed the most since 2000 and those on commercial paper backed by assets such as mortgages slipped.

The three-month bill yield increased 0.52 percentage point to 3.61 percent late yesterday as demand for the shortest-dated government debt waned. Top-rated asset-backed commercial paper maturing in one day yielded 5.92 percent, down from 5.99 percent, posting the first drop in three trading days.

"The flight to safety may be diminishing a bit," said Holly Liss, a bond saleswoman in Chicago at Citigroup Global Markets Inc. "We're seeing more calming of the market as T-bill rates come back to normal."

Lacker said the "jury is still out" on whether the Fed has done enough to improve trading in the $1.1 trillion market for asset-backed commercial paper.

"The markets that are under more stress are the high-yield market, non-agency mortgage markets, collateralized debt obligations and collateralized loan obligations markets, and extendible asset-backed paper," said Paulson, a former Goldman Sachs Group Inc. chief executive officer. "Those are markets that we're watching closely."

Investors and economists still bet that Bernanke will have to reduce the benchmark lending rate between banks, now at 5.25 percent, by at least a quarter point on or before the Sept. 18 meeting.

"Financial volatility and the seizing up of credit markets raises the probability" of a recession, said Steven Einhorn, vice chairman of New York hedge fund Omega Partners Inc. "The Fed needs to be proactive and not wait."

Einhorn said slowing inflation and growth of around 2 percent to 2.5 percent give the Fed room to cut interest rates.

Senate Banking Committee Chairman Christopher Dodd said Bernanke agreed to use "all of the tools at his disposal" to restore stability in markets roiled by the subprime mortgage crisis. He added that he didn't ask Bernanke to cut the federal funds rate and that the Fed chief didn't pledge to do so.

Dodd, a Connecticut Democrat who is seeking his party's presidential nomination, said banks should take advantage of lower borrowing costs at the discount window. He spoke after meeting with Bernanke and U.S. Treasury Secretary Henry Paulson.

Yesterday, the New York Fed reduced the so-called minimum fee rate that bond dealers pay to borrow its Treasuries to 0.5 percent from 1 percent.

"We are doing it to provide additional liquidity to the Treasury financing market," said Andrew Williams, a spokesman for the New York Fed. He said the rate was the lowest in the history of the program, which has existed in its current form since 1999.

The central bank on Aug. 17 cut the so-called discount rate half a percentage point to 5.75 percent to direct more cash to companies starved for short-term financing while avoiding an emergency reduction in its broader lending-rate target.

Banks can borrow at the discount rate with a wide variety of collateral, including everything from mortgages -- the market that sparked the credit crunch after defaults rose to the highest in five years -- to municipal bonds.

Lacker told risk managers yesterday that the Fed's district banks would even accept boat loans as collateral. It's up to the banks to establish a value for the assets as they make the loan, he said.

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