This article first appeared in the St. Louis Beacon: October 9, 2008 - On Monday, Federal Reserve Chairman Ben Bernanke told the National Association for Business Economics that the current financial turmoil threatens overall economic growth. "The combination of the incoming data and recent financial developments suggests that the outlook for economic growth has worsened and that the downside risks to growth have increased." He hinted that the Fed would take strong actions to mitigate this decline.
It didn't take long.
On Wednesday, the Fed along with several other central banks cut their benchmark interest rates. The Fed lowered the federal funds rate to 1.5 percent from 2 percent. The Fed said that the "pace of economic activity has slowed markedly" and that "the intensification of financial market turmoil" will likely slow economic growth even more.
This rate cut is significant because it comes two weeks before the FOMC's scheduled meeting. In a situation less dire than this one the Greenspan Fed dropped the rate below 2 percent in December 2001 and left it there until late 2003. Don't be surprised if they take it down to 1 percent at the meeting on Oct. 28 and 29.
This has been a busy week for the Fed. On Tuesday, it announced a new program to start purchasing commercial paper from eligible issuers. Buying commercial paper means the Fed will supply funds to businesses that need daily credit to operate. Once the domain of private investors now, at least temporarily, lending to businesses like Anheuser-Busch or UE has become is another Fed function.
The Fed also announced it will begin paying interest on reserves that banks hold with it. This is a bit arcane, but important. Banks are required to hold reserves against your deposits at the Fed. If banks have more reserves than required by the Fed, they lend them to each other. This is the market that determines the federal funds rate, the interest rate that underlies borrowing costs faced by consumers.
The recent difficulties have pushed the funds rate below the Fed's desired level. By paying interest on reserves, banks are more likely to keep excess reserves at the Fed and earn an interest that is higher than in the market. This "should allow us to better control the federal funds rate" Bernanke stated.
The problem isn't that there isn't any liquidity or that rates are too high. The Federal Reserve is injecting billions into the financial system. Congress' rescue plan, given time to work, also will improve conditions in financial markets and institutions.
The problem is fear. Fear that lending to someone will result in a loss. Fear of taking a risk. The Fed can lower rates and inject as many reserves as it wishes into the system, but until banks and creditors are willing to lend, little will change.
The dramatic actions taken by the Fed and other central banks are aimed at altering the incentives in the financial markets. The Fed and other central banks have abandoned temporarily any notion of fighting inflation and are focused on a potentially severe recession. By lowering borrowing costs, profitable opportunities should arise. That assumes, of course, that lenders will make loans.
This is uncharted territory, "a problem of historic dimensions" in Bernanke's words. In this era of instant gratification, don't be upset when there is no overnight recovery.
The actions taken need time to restore confidence in the system, to restore confidence by lenders and borrowers alike. Policymakers have done about as much as they can. Now it is time for financial markets to wake up and get back to the business of providing credit and funding economic expansion.
Rik Hafer is distinguished research professor and chair of the Department of Economics and Finance and director of the Office of Economic Education and Business Research at Southern Illinois University Edwardsville.