The Fed Finally Got It Right

03/28/2008 02:48 am ET | Updated May 25, 2011

Well, after months of misapprehension, miscommunication and monetary policy missteps, the Federal Reserve finally articulated a coherent position on how it plans to address the instability in our financial markets and the imminent recession that has both Wall Street and Main Street panicked over the prospect.

Wednesday, Ben Bernanke and company cut two key short-term interest rates a half-point apiece, only one week after cutting those same rates by three-quarters of a percentage point, amidst a global market meltdown.

The Fed's decisive action, which has taken short-term interest rates down 2½ percentage points in less than six months, coupled with a new and open-door policy with respect to further rate cuts, has finally had an impact on market psychology, witness yesterday's big stock market turn-around. With any luck the Fed's actions however late, may blunt the impact of the housing recession, the bear market in stocks and the increasingly broad-based malaise in the economy.

To be sure, we are not out of the woods yet. There are some potential large scale financial market problems hiding out there, like rabbits in a woodpile, and could jump out at us at any time and scare the bejeezus out of all of us.

Having said that, the contents of the Fed's statement, that accompanied yesterday's rate cuts, showed, for the first time since the credit crisis began last summer, that it stands ready to calm the financial markets and protect the economy with all the tools at its disposal.

No doubt the ride will be bumpy from here. One need only review recent economic statistics to understand the severity of our economic problems.

  • The unemployment rate has moved up to 5% in the last several months, while 17 thousand jobs were lost in January (as reported this morning), the first job loss since August of 2003, while unemployment insurance claims hit the highest levels in years, as reported this morning. Both indicators are consistent with the onset of an economic downturn.
  • Manufacturing indicators are showing signs of deterioration, an ominous portent of future economic activity.
  • The dollar's unrelenting slide is indicative of an increasing loss of confidence in the U.S. financial system, as is the safe-haven buying of gold, which is at a record high, well above $900 an ounce.
  • Residential real estate is suffering its worst recession, arguably since the "Great Depression." Home prices have fallen a whopping 8.4% nationally, the first time that home values have declined across the country since the 1930s.

In addition, home sales have plunged by record amounts for both new and existing homes while inventories of unsold homes have reached almost 10 months worth of supply. Housing starts have tumbled more than 50% from the peak of homebuilding activity, a decline that historically has encompassed an entire down-cycle in real estate. This decline happened in a much-compressed 12-month period!

  • Big Investment and Commercial Banks will continue to write off bad debts, whether they are tied to residential real estate, exotic credit market derivatives or, soon, commercial real estate loans. The heavy losses will keep lenders from extending credit to individuals and business, dampening any economic rebound that may be in the offing.
  • Municipal Bond Bombshell: While most of us thought, over the last couple decades, that insured municipal bonds were nearly the safest of all investments, we have now found out that the firms that insure muni-bonds, like MBIA, AMBAC, FGIC and ACA, have also been insuring far more risky securities, like derivatives linked to sub-prime mortgages and other arcane vehicles.

Suddenly, with those debt instruments collapsing in value, the insurers are on the hook for tens of billions of dollars or more of insurance payments and they simply don't have the money to back the bonds they insured. As a consequence, their impairment could lead to a wholesale liquidation of municipal bonds, since those who bought them, thinking they were insured, might dump the bonds for lack of protection that as promised by these wayward insurers.

These insurers are so tapped out right now, MBIA announced a better than $2 billion loss this week, they could never make good on the insurance they promised for municipal bonds, let alone the crazy credits they backed in the last several years.

Regulators are looking at ways to extend emergency credit lines to the insurers, which could stop this budding bond problem dead in its tracks. The only problem with the bailout plan being discussed, is that few institutions have the wherewithal to back the bond insurers; given the immense financial problems they have themselves.

But enough gloom and doom talk for one day. The Fed will continue to cut interest rates until the markets are calm, financial institutions can lend again and the economy shows signs of life.

The President and Congress are working to pass an economic stimulus plan that should, or could, give the economy a short-term shot in the arm.

And regulators are working to fix the foreclosure problems in residential real estate and potential problems in other areas of the markets.

So, as they say on Wall Street, let's put a little lipstick on this pig and hope the idea sells! If it doesn't... pork bellies all around!