Fed tackles credit crunch with controversial liquidity boost

Source: Exec Digital Canada

Date :3/12/2008 2:09:50 AM

The Federal Reserve eases fears of a troubled economy as it pumps $200 billion into the bond market, increasing stocks by a five-year high.

In a move that some experts claim will “scare the hell out of everyone”, the Federal Reserve has taken the most radical of steps as it hopes to plug the ever widening, ever worsening credit crisis.

Following the decision on March 7 to inject an initial $200 billion into the economy in the shape of increased loan auctions and repurchase agreements, the Fed has stepped up with another $200 billion, this time to help banks and businesses liquefy their assets.

That’s $400 billion in a week. The Fed is serious.

And this all comes on top of the news that interest rates are set to drop again. Rates have already been slashed from 5.25 to three percent, and analysts expect them to fall again later in the year – as low as one percent by the end of July, claims Paul Ashworth, chief economist at Capital Economics.

Can it work?

This is the third definitive effort made by the Fed and other co-ordinated central banks to stem the flow of the credit crisis that began eight months ago.

But will it be a case of “third time’s a charm”?

G-10 central banks worldwide appear ready to do whatever it takes to ease the situation and reassure banks and investors that there is hope yet.

Investors, at least, seem buoyed by the announcement, willing to pour their money back into the stock market, stocks rising by the fastest rate for five years. Maybe – just maybe – the world’s economy is starting to stabilise.

Economists, however, appear less convinced – and understandably so. Many believe the fickle nature of the average investor is what has driven this surge in stocks, but the real problem runs far deeper. “There is no fix to the problem in the markets that is going to be quick and easy,” says Nick Parsons, head of strategy at NAB Capital.

But that’s not the greatest worry for some. Perhaps more concerning is the lack of any apparent contingency plan. “It’s a very bold thing for the Fed to do,” said one analyst. “But if it doesn’t work, there is no plan B.”

So it seems like the Fed is just playing this one by ear, making up the rules as it goes along. But then again, what else can it do?

Worldwide action

The Fed’s not the only central bank taking action. Other banks are weighing in too in a co-ordinated effort to solve the problem. The Bank of England has committed a rolling injection of £10 billion ($20 billion) alongside the announcement that the European Central Bank plans to auction up to $15 billion in extra funds later this month. And that’s just the tip of the iceberg.

The response to the credit crunch has been quite overwhelming, with central banks agreeing to pump in excess of $260 billion into credit markets following a meeting of the Bank for International Settlements in Basle on Monday.

Too little?

It’s a big commitment, certainly, but is it enough to make a difference?

David Rosenberg, chief North American economist at Merrill Lynch & Co., doesn’t think so, saying the action "is simply not big enough”.

"The size of the auctions, while sizable in terms of the Fed's balance sheet, are actually fairly small in light of the overall credit situation and in no way does this solve - or is intended to solve - the massive losses in the banking sector," Mr. Rosenberg suggested in a research note yesterday.

Whether this financial injection will make any impact remains unclear, but many remain sceptical.

March 12, 2008