By John W. Schoen Senior producer
msnbc.com
updated 9/16/2008 8:23:06 PM ET 2008-09-17T00:23:06
ANALYSIS

Despite pressure from the financial markets to cut interest rates, Fed Chairman Ben Bernanke and the board’s policymakers sent a strong signal that they are hanging tough by leaving rates just where they are.

Major Market Indices

Even as oil prices continue to fall toward $90 a barrel, Bernanke & Co. warned that the inflation outlook remains “highly uncertain.”

Many had hoped the Fed would offer up another cut to calm the storm swirling through the global financial markets. The upheaval so far has caused the collapse of Lehman Bros., the shotgun sale of Merrill Lynch and increased worries about the possible failure of insurance giant AIG.

Several publications reported late Tuesday that the Fed was close to a deal to loan at least $85 billion to AIG in exchange for an 80 percent equity stake.

Though the Fed held steady on rates, the central bank is hardly sitting on its hands. As the markets churn through the damage inflicted by hundreds of billions of dollars in losses from bad loans, the Fed continues to lend money to banks and investment firms. And it has become a lot less choosy about the assets it takes back as collateral.

“Through the back door, with the (lending) facilities they have, they're making a lot of credit available," said John Silvia, chief economist at Wachovia. “They're easing that way, but not changing the federal funds rate."

As banks continue to reasses the value of their mortgage loans and related investments, they face continued losses. Cutting the federal funds rate, and lowering the cost of money, helps banks boost profits on new loans and make up for the losses on loans that go bad.

By holding rates steady, the Fed is setting a limit on how far it is willing to cut rates to help banks repair their battered balance sheets. Just as Treasury Secretary Hank Paulson cautioned Monday that ailing financial firms shouldn’t count on taxpayer-funded backstops, Bernanke signaled Tuesday they the Fed's primary mission is fighting inflation and promoting economic growth — not aiding ailing banks.

“I think what they're trying to say is that they do have a lot of tools in their tool box and that they’re using them aggressively," said Ken Volpert, a portfolio manager at The Vanguard Group.

Leading up to the meeting of the Fed, the price of money in the futures market indicated that investors expected a quarter-point rate cut to help struggling financial companies and give a boost to the stock market, which Monday suffered its worst day in more than six years. After the Fed’s decision was announced Tuesday, traders on the floor of the New York Stock Exchange booed loudly.

“Some Fed governors are on another planet," said William Gross, chief investment officer of PIMCO, a large bond fund. "Because clearly we're in a deflationary environment in all asset classes, exemplified by oil in recent weeks."

"Now that inflation is no longer the visible enemy, it pays to shift the focus to stopping the slide of the real economy, via easier monetary policy, here and abroad," he said.

The other main argument for a rate cut is to help revive the faltering economy and stop the rising pace of job losses. But it’s not clear that a further cut in rates would help, according to former Fed Gov. Robert Heller.

"The Fed should remain very steady because at the moment, we already have negative real interest rates in the market," he said. "Long-term rates have come down drastically. So lower (short-term rates) really don't provide any great assistance to the economy right now."

The economic impact of rate cuts also could be limited by the nature of the current credit crunch. Tight credit conditions are less a function of the interest rate the Fed is charging lenders. The problem is that lenders are nervous about the spread of credit losses and the weakness in the economy. Until the fears of those credit losses subside, lenders will be reluctant to extend more credit.

In the meantime, some Fed watchers think rates will stay where they are for a while.

"The FOMC seems to be solidly on hold for the foreseeable future," Michael Hanson, a senior economist at Lehman Bros., wrote in a note following the announcement. "As the growth outlook deteriorates and inflation measures drop, a movement toward some additional easing of rates to address economic fundamentals seems likely."

The Fed’s announcement came as financial markets nervously awaited the outcome of last-ditch efforts to shore up insurance giant AIG, whose stock has been battered by reports of big exposure to possible losses from debt-related investments known as credit default swaps. As the government worked to orchestrate a private bailout, there was speculation that the Fed would have to act to prevent AIG’s failure from reverberating throughout the financial system. Rumors that the Fed was prepared to step in as a lender of last resort helped calm the market’s reaction to the decision on rates, according to John Ryding at RDQ Economics.

“If no such assistance is forthcoming, we think that market weakness could well force the Fed to cut rates,” he said in a note following the Fed’s decision.

The Fed could also backstop a failed AIG with increased lending to banks that may suffer collateral damage. But Heller believes the Fed should not extend that assistance directly to AIG.

"I think it should be the responsibility of the Treasury first and foremost rather than the Federal Reserve," he said. "Because it's not a bank, it's not a Federal Reserve-supervised institution."

Reuters contributed to this report.

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