Has Smoke and Mirrors Worked?

In an inspired bit of stagecraft, Senate Banking Committee Chairman Christopher Dodd reported today on a meeting with Fed chairman Ben Bernanke and Treasury secretary Henry Paulson that the Fed stood ready to use “all of the tools at his disposal” to address the current money market liquidity meltdown and general credit market distress.

This was brilliant. Neither Bernanke nor Paulson has made a reassuring statement in their own names (Paulson’s remarks were if anything sobering). This gives Bernanke wriggle room, particularly since investors projected what they wanted to hear onto Dodd’s remarks, namely, that the Fed stands ready with an open checkbook. For the moment, the money markets have abruptly reversed their flight to quality, a very positive development. As the Financial Times tells us,

Money markets on Tuesday staged a dramatic reversal of Monday’s flight to safety, after an influential US senator fuelled expectations that the US Federal Reserve would soon cut interest rates…..

The revelation helped turned around investor sentiment after an earlier warning by Mr Paulson that there was no quick solution to problems in credit markets….

Fed sources played down the significance of Mr Dodd’s remarks, indicating that there was no change in Fed policy since Friday, when it put out a statement saying it was “prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets”.

While our “smoke and mirrors” headline may sound dismissive, it is important to recognize that Fed’s tools, the ones Dodd invoked, are few in number and crude indeed. And the crisis in the money markets was a crisis of confidence, a panicked, irrational overreaction to some legitimate underlying issues.

The more the Fed can rely on legerdemain rather than liquidity to keep the markets functioning, the better off we will be. It seems that a real pol like Dodd is giving lessons to the newbies.

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  1. dis

    Martin Wolf over at the Ft is predicting a cut in a piece I found very interesting.

    Here is an excerpt

    Nothing that has happened has been a product of Fed folly alone. Its monetary policy may have been loose too long. The regulators may also have been asleep. But neither point is the heart of the matter. Assume that the US remains a huge net importer of capital. Assume, too, that US business sees no reason to invest more than its retained profits. Assume, finally, that the government pursues a modestly prudent fiscal policy. Then US households must spend more than their incomes. If they fail to do so, the economy will plunge into recession unless something else changes elsewhere.

    This is why the Fed is sure to cut interest rates if today’s crisis seems likely to reduce the supply of credit (as surely it will). Would that work or might the Fed find itself “pushing on a string”, as the Bank of Japan did so painfully in the 1990s and early 2000s? A good guess is that the policy would work. But if it did not, there would be only two ways out: a huge fiscal expansion in the US or a huge reduction in the US current account deficit. The former looks undesirable and the latter inconceivable.

    Today’s credit crisis, then, is far more than a symptom of a defective financial system. It is also a symptom of an unbalanced global economy. The world economy may no longer be able to depend on the willingness of US households to spend more than they earn. Who will take their place?


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