The Fed took an important first step yesterday to relieve the financial system liquidity and mortgage credit crisis by reducing its discount rate for loans to member banks by one-half of a percent to 5.75 percent from 6.25 percent. Stocks cheered loudly. In effect, the central bank reaffirmed its traditional role as lender of last resort in times of financial emergency.
Essentially, the Fed seems to be saying that it will not allow money-good mortgage lenders such as Countrywide, Thornburg, and others to suffer bankruptcy from lack of liquidity. If solvency were the problem, there's nothing the Fed could or should do. But in a cash crunch, such as we have today, the central bank made the right move.
Importantly, Bernanke & Company have changed their policy leaning away from inflation-worrying to economy-worrying. This is a major shift. The biggest in several years. And well they should. Banking problems are far from over.
The commercial paper market for short-term corporate loans is completely dysfunctional. Mortgage-backed securities and corporate loan packages are still suffering from difficult pricing decisions and very little trading. No one really knows the full problem or the size or who owns what when it comes to the subprime virus. Loan transparency is inadequate. Cash hoarding is everywhere.
Investors are flocking to short-term Treasury bills in order to avoid any risk whatsoever. T-bill rates have collapsed all the way down to 3.5 percent. But if investors are putting all their money in government paper, they won't be financing the business sector that makes our free market capitalist economy hum.
The best thing the Fed can do now is to reduce its basic target rate in line with the decline of Treasury bill rates. In other words, Bernanke should follow the guidance of the free open market rather than rely on the economic models of the Fed staff.
This free market thinking suggests that the 5.25 percent fed funds target rate should fall a full percentage point as the bank keeps pumping in more cash to back-stop the financial system and promote future economic growth. At lower tax rates this new cash will stimulate more investment and employment without reigniting inflation. President Bush will veto any tax hikes. That keeps the door open for Fed easing.
The cash increase will be absorbed by gains in business investment and production. Credit deflation can be turned into credit stability. That will keep the Goldilocks Main Street economy alive and well.
But Mr. Bernanke should not wait until the next regularly-scheduled meeting on September 18th. He should follow on the discount rate cut with a 50 basis point fed funds rate reduction this coming week.
The credit freeze that has engulfed Wall Street could be solved in the next eight to ten weeks if the Fed acts sensibly and quickly.