The Sub Prime Crisis: What next from Fed?

(Ref: The Economist, dt. 18 August; The Financial Times, August 20)

How will the Fed respond to the recent turn of events? Many analysts are recalling what happened in 1998, as they try to predict what might happen now. In 1998, against the backdrop of the Asian currency crisis, the collapse of the Russian rouble and the Long Term Capital Management (LTCM) bankruptcy, the Fed cut interest rates by 25 basis points each, three times, beginning on September 29. Accordingly some analysts are predicting that the Fed will cut interest rates by 25 basis points on September 18 and again in October if required.

Expectations from the Fed are high keeping in view that the venerable financial institution played a key role in restoring sentiments both after the 1987 stock market crash and the 1998 LTCM collapse. Knowledgeable observers argue that the Fed, however, will be careful to avoid moral hazard. It will send signals based on the possible impact of market events on the real economy, not because of the plight of the financial intermediaries alone.

Meanwhile, the Economist in its recent issue has examined the kind of role that a Central bank should play during such crises. The Economist recalls how in 1873, the famous writer Walter Bagehot urged the Bank of England to stave off financial panics by “lending quickly, feely, readily at a penalty rate of interest to any bank that can offer good securities as collateral.” By lending liberally, central banks make it less likely that their money will be needed. By demanding good collateral, the central banks can distinguish insolvent banks from illiquid ones and by charging a penal rate of interest, they ensure that they are truly the lenders of last resort.

What Bagehot mentioned in 1873 is exactly what the Fed (and the European Central Bank) seems to have done in the past few days. The only difference (but a big one) is that the Fed did not charge a penal rate of interest. Meanwhile, William Buiter and Anne Sibert, two London based academics argue that central bankers must become the “market makers of last resort,” by setting a price for securities that can no longer be sold on orderly markets. This will prevent distress sales that can further aggravate the market turmoil. For example, the central bank could make a market in CDOs, either by accepting them as collateral or by buying them out right. But Buiter also makes it clear that hedge funds should not receive from central banks the same kind of protection as banks, unless they accept similar restrictions (i.e., like those applicable to banks) in the way they conduct their operations