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Federal Reserve Plans Interest Rate Cut to Revive Economy

September 17, 2007 at 6:15 PM EST
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GWEN IFILL: Now, a closer look at what the Federal Reserve has been up to lately and what it’s expected to do tomorrow. Economics correspondent Paul Solman is our guide.

PAUL SOLMAN, NewsHour Economics Correspondent: The Federal Reserve Bank of the United states, when its Open Market Committee meets tomorrow, run by Chairman Ben Bernanke, it will simply be doing its business as usual, trying to fine-tune the economy by adjusting the famous federal funds interest rate. The purpose: to keep the economy stable long term, with low inflation and high employment.

Well-summed up in the punch bowl metaphor of a Fed chairman many years ago, the Fed’s job is to take away the punch bowl when the party gets going — raising interest rates, that is, when the economy is growing too fast, to discourage people from giddy overspending or tipsy speculation which would fuel inflation — or, by contrast, when torpor takes over and the fear of recession rears its head — by spiking the economy, in effect, lowering interest rates so people will invest and spend more, and the economy won’t get depressed.

For several years, the Fed has been taking away the punch bowl, raising the Fed funds interest rate steadily from 1 percent to 5.25 percent from 2003 until the summer of 2006. Then it paused for a year.

Tomorrow, it’s expected to begin lowering that interest rate, which banks charge each other, and which gets passed onto the rest of us in our mortgages, car loans and the like. That’s because the Fed’s now concerned about a weakening economy, led by the housing downturn, an economy with lower spending, less investment, fewer jobs.

Now maybe you’ve heard all of that before. But in the past month or so, the Fed has done something else, as well. It’s actually done the job for which it was originally intended: to rescue the economy in a liquidity crisis.

Last month, remember, U.S. and world markets were plummeting, panicking, and they’re still jittery. A panic is a liquidity crisis, says economy historian John Wallis, and he adds:

JOHN WALLIS, Professor of Economics, University of Maryland: It could be disastrous. So the Fed was explicitly designed to give the banks liquidity for their loans, so the banks could come to the Fed, sell their loans, get cash, meet their depositors, liquidity crisis over.

Defining "liquidity"

John Wallis
University of Maryland
There have been about 10 financial crises in which large numbers of banks had simply closed up. People couldn't get their money out of their accounts...the Federal Reserve was primarily designed to prevent that kind of financial panic.

PAUL SOLMAN: Now, before we go any further, two definitions. Liquidity is the ability to turn any asset into quick cash without it losing value. A liquidity crisis is when lots of assets that used to be tradable into quick cash no longer are.

And, indeed, last month, seemingly all at once, stocks, bonds, mortgage-backed securities could no longer be quickly bought and sold for what they'd been worth moments before, a liquidity crisis. In fact, a long history of liquidity crises throughout the 19th century is what led to the Fed's creation in the first place.

JOHN WALLIS: There have been about 10 financial crises in which large numbers of banks had simply closed up. People couldn't get their money out of their accounts. And that had happened periodically in the 1830s, the 1850s, the 1870s, the 1890s, again in 1907, and the Federal Reserve was primarily designed to prevent that kind of financial panic.

PAUL SOLMAN: The Fed was actually formed in 1913, as the government's bank to issue currency, regulate other banks, and oversee the financial system. A key function from the get-go: to pour liquidity into the economy to counteract a financial panic, a crash, a liquidity crisis.

Former Fed economist Adam Posen.

ADAM POSEN, Deputy Director, Peterson Institute: A crash is a sustained drop in the value of assets. So it can be stocks, it can be bonds, something that's traded. A liquidity crisis is when that crash has effects on the core banking system, when it has effects on the broader credit markets rather than just the people who hold those original stocks.

The great liquidity crisis

Adam Posen
Peterson Institute
People look back at the Fed in '29, '30, and say that was one of the biggest mistakes ever made in policy.

PAUL SOLMAN: The most famous liquidity crisis, of course, was the Great Depression of the 1930s, which began with the crash of 1929. A series of bank panics soon followed.

But despite having been created to provide liquidity in a panic, the Fed didn't, afraid of bailing out imprudent banks. A liquidity crisis doesn't distinguish, however, between good business and wild speculation.

ADAM POSEN: It doesn't necessarily pick out, "Oh, you have a good business project. Oh, you were a nasty speculator. You're unemployed; you're not." It doesn't work that way.

So this is why, in the end, people look back at the Fed in '29, '30, and say that was one of the biggest mistakes ever made in policy. And, frankly, our current fed chair, Ben Bernanke, that's what he's famous for, was for doing some of the key analyses on, what were the mistakes made in '29, '30, that most people now accept as the mainstream story?

PAUL SOLMAN: No fear, that is, that the Fed wouldn't act this time.

Now since the liquidity of anything -- a stock, a bond, a painting, a house -- is how fluidly it can be turned into cash, currency is obviously the most liquid thing around, followed closely by what the banks call "cash," the deposits they hold with the Fed as federal reserves, and then by what investors call "cash," the short-term treasury bills of the U.S. government.

As for illiquid, how about my house? It, too, is an investment, though not a very liquid one at all, and a whole lot less liquid than it was just a year or so ago because houses aren't selling real fast here in the Boston area.

And that takes us to the recent crisis, triggered by an investment that was supposed to be liquid, but turned out not to be, mortgage-backed securities. Professor John Wallis explains.

JOHN WALLIS: We've securitized mortgages, which is that a bank has lent me money and turned around and sold my mortgage to somebody else. And groups have emerged, first organized by the government and then by the private market, which packaged those mortgages and sold them to investors.

Encountering unaffordable interest

Adam Posen
Peterson Institute
When you're thirsty, ice doesn't do you any good unless you can unlock the liquid. Similarly, an asset that looks like perfectly fine stuff, when the market falls apart for it, it doesn't do you any good.

PAUL SOLMAN: Those mortgage-banked securities were stepped in a direction of greater liquidity compared to the traditional 30-year mortgage, until, that is, homebuyers, who had been taking ever riskier adjustable rate loans, ran up against rising interest rates and payments they could no longer afford.

ADAM POSEN: Now what happened is that process went in reverse. Everybody said, "I don't really trust what is inside those bundles, because I don't know who really did the evaluation of the worth of this. I also don't know that there's as much interest in buying mortgages as there was a few months ago. So I'm going to stop buying as many of those as I used to."

And that starts the cycle. The mortgage-backed securities go down in value. Somebody had borrowed against the mortgage-backed securities that looked like a solid asset. They, then, try to sell off more of them to make payments back to the original bank. The original bank says, "Well, I don't really want to be paid back in mortgage-backed securities. I want to be paid this cash." That leads to another round of selling, and so on and so on.

PAUL SOLMAN: And eventually, as investors had to come up with the cash, they started selling not only mortgage-backed securities, but all sorts of assets, stocks, bonds and the like, which then dropped in value, and thus lost their liquidity, as well. The freeze was on.

ADAM POSEN: When you're thirsty, ice doesn't do you any good unless you can unlock the liquid. Similarly, an asset that looks like perfectly fine stuff, when the market falls apart for it, it doesn't do you any good as a basis for borrowing or as a basis for paying anybody.

PAUL SOLMAN: So at the risk of going to the faucet once too often, in mid-August, to keep the U.S. economy from freezing up, the Fed provided liquidity. It did so by loaning money to banks at a discount, so the banks could buy and sell otherwise illiquid securities.

OK, one last question: Is the Fed's job now done?

ADAM POSEN: The Fed's job, as far as it goes for stability, is probably done, and then they keep an eye on the forecast for the real economy, and they say, "OK, there's this much housing decline, this much employment decline. Maybe if we cut rates some more, we can offset some of that." That's the normal Fed job.

PAUL SOLMAN: In other words, now that the Fed has done the job of providing liquidity in a crisis, it can get back to its usual work of trying to fine-tune the economy, as it will tomorrow by, many expect, lowering the interest rate it usually fiddles with, the federal funds rate. And that's because our economy now is more threatened by a general lack of punch than by, say, as in the last few years, going on a bender.

GWEN IFILL: If you want to find out how markets and interest rates affect your finances, you can send any questions you have to Paul Solman. He'll answer them on our NewsHour Insider Forum. You can find it on our Web site at PBS.org.