Why the Fed can't put out the fire

Even many of those who believe Fed must make another big rate cut Tuesday concede it can't do much to calm troubled markets.

EMAIL  |   PRINT  |   SHARE  |   RSS
google my aol my msn my yahoo! netvibes
Paste this link into your favorite RSS desktop reader
See all CNNMoney.com RSS FEEDS (close)
By Chris Isidore, CNNMoney.com senior writer

Issue #1
  • This week at 12 pm ET, CNN explains how the slumping economy affects you.
  • Bailout backlash
  • Impact of the mortgage crisis
Has the federal government taken the necessary steps to turn the economy around?
  • Yes
  • No
Mortgage Rates
30 yr fixed 3.80%
15 yr fixed 3.20%
5/1 ARM 3.84%
30 yr refi 3.82%
15 yr refi 3.20%

Find personalized rates:

Rates provided by Bankrate.com.

NEW YORK (CNNMoney.com) -- With Wall Street hit by a crisis of confidence, many are hoping the nation's central bank can save the day.

The Federal Reserve's main weapon: Cutting interest rates, and most economists expect a big slash of three-quarters of a percentage point on Tuesday.

But even those economists in favor of such a move concede it will do little to calm investor fears.

"It doesn't address the fundamental problems, which is that financial markets are just scared," said David Wyss, Standard & Poor's chief economist. "The Fed is trying, but they don't have a magic wand to wave and make everyone confident again."

In the past week, investors have come to expect even more aggressive action from the Fed.

The sudden collapse of investment bank Bear Stearns sparked fears that other Wall Street banks could be at risk. Shares of Lehman Brothers (LEH, Fortune 500) plunged more than 25% in morning trading on Monday. Concerns that another institution could collapse is one reason that the Fed will probably deliver another big rate cut.

But Rich Yamarone, director of economic research at Argus Research and a critic of the Fed's rate cuts, argues the Fed is feeding current market fears with emergency moves like Sunday night's decision to make loans directly to Wall Street firms instead of just banks.

"Anytime you act on a Sunday night during '60 Minutes,' if you don't think that will engender fear, I don't know what does," said Yamarone.

He added that the Fed should not be trying to prevent failures by Wall Street firms.

"It was almost naive to think this wasn't going to happen to someone," he said. "You don't have a credit crisis of this magnitude and have every player sidestep calamity."

But Lyle Gramley, a Fed governor from 1980 to 1985 and now a senior economic advisor for the Stanford Washington Research Group, said that such a failure would have far broader implications for the economy and the financial markets and the Fed has to do what it can to avoid that.

"If the Fed had sat aside and let Bear go down the tubes, the cascading effects would have been ghastly," he said.

Still, Gramley concedes the Fed has only a limited ability to deal with market fears. And he said that makes this economic crisis the most difficult challenge for the central bank since the Great Depression.

"In all past recessions, I was always quite sure that if the Fed stomped hard on the gas pedal, the economy would turn around and start to grow," he said. "But they've now stomped hard on the gas, and credit is not more available, it's less available."

Gramley and some other experts believe the solution to the current credit crisis will have to come from Congress, not the Fed, and that the federal government will have to take steps to bail out both Wall Street firms holding mortgage-backed securities as well as homeowners who have mortgages with balances greater than the value of their homes.

"I think the federal government is going to have to recognize taxpayer money will be involved and the sooner we get going on that, the better," Gramley said. "The longer it takes to do that, the more expensive the bailout will be."

The Fed took steps to assume some of that credit risk last week when it agreed to accept mortgage backed securities as collateral.

Still, Yamarone and other Fed critics argue that another round of rate cuts will do little but drive the value of the dollar lower versus the euro and the yen, which in turn will further drive up the prices of commodities such as oil and gold.

"Not one company is saying monetary policy is restrictive or that the current interest rate levels are impeding them from investing," said Yamarone. "A (full percentage point) cut would send the dollar into a potential collapse. We're in a free fall now, wait till you see what a collapse looks like."

But many others think the Fed has no choice but to keep slashing rates.

"It helps, even if it doesn't solve the problem," said Wyss. "You need to keep the cost of borrowing down. It's not the optimal solution, but it's better than nothing."

And no matter what the Fed does, market fears probably won't go away any time soon. After all, some investors will probably take more Fed cuts as a sign that the central bank sees more trouble ahead.

"The market is going to stay worried, regardless of what the Fed does. It's heads you lose, tails you lose," Wyss said.  To top of page

They're hiring!These Fortune 100 employers have at least 350 openings each. What are they looking for in a new hire? More
If the Fortune 500 were a country...It would be the world's second-biggest economy. See how big companies' sales stack up against GDP over the past decade. More
Sponsored By:
10 of the most luxurious airline amenity kits When it comes to in-flight pampering, the amenity kits offered by these 10 airlines are the ultimate in luxury More
7 startups that want to improve your mental health From a text therapy platform to apps that push you reminders to breathe, these self-care startups offer help on a daily basis or in times of need. More
5 radical technologies that will change how you get to work From Uber's flying cars to the Hyperloop, these are some of the neatest transportation concepts in the works today. More

Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.