The Wall Street Journal-20080123-Managing a Panic
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Managing a Panic
Yesterday's emergency rate cut by the Federal Reserve seems to have stalled a global selloff in equity markets, and for that we can be grateful. We'd have preferred a narrower pledge of liquidity for all comers through the discount window, but then riding shotgun in a stampede can sometimes call for improvisation.
And such a panic is unfortunately what we have. The Fed explained its 75-basis-point move a week before its regular meeting "in view of a weakening of the economic outlook and increasing downside risks to growth." The central bankers are especially worried that struggling regional banks have stopped lending to small and medium-sized businesses, which are the U.S. economy's chief job creators. The job market has been the last bastion of growth amid the housing recession and credit crunch, so the Fed's concern is understandable.
The rate cut will reduce the cost of borrowing by lowering mortgage and other benchmark interest rates. In the best case, the lower cost of capital will give banks more confidence to lend, and in the process increase the demand for money, which might ease any inflationary pressures from monetary easing. As we say, this is the best case.
The worst part of yesterday's decision is that it looked like more Fed appeasement of banks and equity traders, suggesting even a hint of panic by the Fed itself. Chairman Ben Bernanke had already signaled that the Fed would cut rates sharply at its regular meeting next week, and in retrospect that candor only invited more Wall Street agitation to speed it up. Mr. Bernanke's interest in more Fed transparency is admirable, but we'd prefer if he saved his explanations for when he acts.
Yesterday's move might also have had more credibility if it had been coordinated with the European Central Bank. It speaks volumes that ECB President Jean-Claude Trichet has so far declined to follow the Fed's rate-cutting lead. Either Mr. Trichet doesn't think Europe's credit problems are all that serious, or perhaps he thinks the Fed's policy is misguided. This has given the Fed less protection against a further reduction in the dollar's value against the euro, and could yet inspire more trade tensions. Mr. Bernanke's dollar diplomacy could stand improvement.
The larger risk is that these rate cuts will contribute to a further flight from the dollar, along with more inflation down the road. Gold jumped yesterday, but on the other hand oil fell, perhaps on expectations of lower demand from slower global growth. Commodity prices and foreign-exchange markets bear watching in the coming weeks, and if they spike we'll know that investors expect the Fed will keep bowing to political pressure.
Futures markets are already pricing in further rate cuts deep into 2008. This is hardly a vote of confidence in the Fed, and our advice would be that if Mr. Bernanke wants to cut further he do so fast and be done with it. This would shift market expectations that still-lower borrowing costs aren't coming, and would itself help to revive lending.
Above all, Mr. Bernanke needs to be clear with everyone -- Congress, Wall Street, investors -- that easier money is not some magic elixir for the underlying problem of bank insolvency. The credit and real estate losses are real and have to be dealt with. This requires slow and steady workouts, raising new capital, and in some cases regulatory action to arrange mergers and rescue institutions whose failure could lead to problems in the larger banking system.
This is the advantage that the discount window provides, both providing liquidity to those in need and giving the Fed information about which institutions are in trouble and why. Unlike rate cuts, this is not glamorous work. But it is the best way to deal with insolvency while running the fewest systemic risks.
It would also help if President Bush and Congress both took a hint from the market selloff following their "stimulus" announcements late last week. Investors clearly view the tax rebates and new spending as useless in promoting growth. The White House signaled yesterday that Mr. Bush may be open to a larger package than his $150 billion proposal, but size isn't the issue. The problem is his reliance on "temporary" Keynesian nostrums that won't increase incentives to invest and take risks. Treasury Secretary Hank Paulson's defense of the package yesterday was, well, let's be kind and call it uninformed.
If Mr. Bush really wants to change the terms of the economic debate, he'd use his State of the Union address to make the case for a tax cut stimulus that is marginal, immediate and permanent. No doubt Members of Congress are saying that can't pass, and some in the White House want to be able to point to a legislative "stimulus" victory in an election year. But if the economy stays weak, Democrats will still blame the White House.
None of this is making life any easier for Mr. Bernanke. But sooner or later he has to make clear that managing a panic requires as much discipline as liquidity.
