Ben dials 911

Today was big. Bigger than 9/11. No, I’m not being unpatriotic. It’s just that this is what Ben Bernanke, the Fed’s Chairman, wants us to believe.

I went to the office early in the morning, admittedly with (more than) a whiff of nervousness about how the US markets will open after yesterday’s stock-market carnage in Asia and Europe. And then the “bomb” fell: In an emergency move, the Fed cut the federal funds rate to 3.50% from 4.25%--a “75 basis point cut”, if you want to sound like a pro. Wow! The last time the Fed cut rates in an emergency meeting was six days after the 9/11 terrorist attacks. I mean, we already knew that the economy is in a mess, but still, that’s big!

Indeed, the Fed justified its move by citing the difficult borrowing conditions for businesses and households, the deterioration in the housing market and the recent poor employment data. But really, could Ms. Economy not wait for another week, on January 29th, when the Fed was scheduled to meet anyway and get its chance to act in as drastic a fashion as needed? Why the code red? And can someone tell Ben to stop acting like a panicked rookie?

I don’t want to downplay the bloodbath that we might have seen in the markets today in the absence of the Fed’s move. I own stocks myself and, yes, it hurts! But since when did the Fed add to its dual mandate (of price stability and full employment) a third one, that of spoiling the markets? I mean, let’s say there is value in some ad hoc salvaging of the markets from their own “irrational” behavior; but then why not try to also rein them in before their “irrationality” creates all sorts of bubbles and mispricings? Yeah yeah, I’ve heard it before, “you only know it’s a bubble once it bursts.” But then I challenge you to a duel over the identification of a “market correction” versus a “market collapse.”

More importantly: Will the cut work?

As far as the “real” economy is concerned, the Fed’s cut undeniably provides a good deal of help—especially since may be more to come. Financing conditions become easier for businesses, banks and households, and the housing market, which has been the source of the mess, will benefit from lower interest rates for new mortgages (or the refinancing of existing mortgages).

But when it comes to assuaging the markets, that’s a bit different. The root of the market meltdown continues to be, largely, uncertainty over the health of major financial institutions, from Citigroup to Merrill Lynch to Bank of America, in face of losses from investments linked to the subprime mortgage sector. The trigger for the most recent dive was two pieces of bad news about two sellers of insurance against potential default on some debt instruments: ACA Capital and AMBAC. The former was near collapse and the latter was downgraded (see here for explanation of "downgrade"), and this led to fears that the price of the debt instruments these guys insure will go into a freefall. Now guess who has invested in these instruments? The Merrill Lynches and Citigroups of this world, so the news on ACA & Co. foreshadowed even more losses for these banks and more cuts in lending!

It’s really hard to see how a Fed interest rate cut will help resolve the problem of lack of information on the potential size of banks’ losses, or the uncertainty over what is the “fair” price for all these exotic instruments that are burdening banks’ portfolios and are partly preventing them from lending more. That’s why the market impact of the Fed’s cut is probably at best temporary.

So fasten your seatbelts. And Ben, we liked you more in your cool. At least I did!

Glossary: The Fed, federal funds rate, bubbles, corrections, basis point (pronounced ”bip”), Uncle Ben