It may not be as sexy as $300 in your pocket, but the Federal Reserve Board’s decision to pump $200 billion worth of Grade A liquidity into financial markets will do more to help the economy than the politically popular “stimulus” plan. The Fed is showing some welcome creativity as it tries to ease a credit crisis triggered by rising mortgage defaults and falling home values.
The tool the Fed most often uses, cutting short-term interest rates, has done little to restore confidence and runs the risk of stirring inflation. Short-term rates have been slashed by 2.25 basis points since last summer — and may be cut once again when the Federal Open Market Committee meets Tuesday. But banks still have too much troubled housing-related debt on their balance sheets, even after writing off billions of dollars in mortgage debt. That’s putting a squeeze on credit availability and upward pressure on rates.
The new Fed effort will allow banks to temporarily swap their troubled mortgage-related assets with Fed-owned safe assets — cash and Treasury securities. In 28 days, the banks have to return the safe assets and take back their troubled mortgage-related assets. The Fed hopes the gears will have been greased by then and that normal market activity in mortgage securities can resume.
There’s no guarantee this will solve the problem. Fed efforts to stabilize financial markets by injecting liquidity in other ways haven’t worked. But this one was greeted with hosannas Tuesday on Wall Street, where the stock market posted its biggest one-day gain in five years. The market gave up some of those gains on Wednesday, but economists still give the plan a good chance of succeeding.
The Fed can’t force banks to lend. It can only create a welcoming environment where that activity can occur. Cutting short-term rates and injecting liquidity are means to that end. Many experts are convinced that credit markets will stabilize only when banks and buyers alike are convinced that U.S. housing prices have bottomed. In the meantime, the Fed is doing it’s best to keep the credit market freeze from further destabilizing the rest of the economy.
Unlike rate cuts, this doesn’t create an inflation risk. Unlike the stimulus checks, this doesn’t add to federal debt. It’s a safe gamble, and it shows that Fed Chairman Ben Bernanke can respond to a crisis in creative fashion.
