NEW YORK (Reuters) - The collapse of Bear Stearns and its potential for contagion will be the Federal Reserve’s primary guiding force on Tuesday in a meeting that could yield as much as a 1 percentage point cut in interest rates.
The situation was becoming so dire that the central bank felt it could not wait until its official meeting day to cut the discount rate. It did so on Sunday night in a rare emergency move aimed at shoring up the banking sector.
Until recently, the Fed seemed to be weighing the need for further monetary easing to buffer a slowing economy against the possibility that inflation would pick up.
Now, the panic in financial markets seems to have overtaken events, and a crisis-mode Fed is simply looking to avert a wholesale breakdown of the American banking sector.
Speculation was rife about who else might be running out money: “Which of the big banks will be next to fail? How many more banks will fail?” University of Maryland economist Peter Morici asked. “The Fed is trying to reassure financial markets that it stands ready to back up the banks, but this is not likely to work.”
In light of such concerns, the central bank will consider the following issues on Tuesday:
SYSTEMIC RISK: The Fed is in crisis mode and now sees its main function as preventing a broader panic that would force more banks to go belly up. It has already pumped over a half trillion dollars into the financial system since the troubles began, and has now indicated its willingness to take on mortgage-backed bonds as collateral, essentially providing a dumping ground for Wall Street’s tarnished securities.
ECONOMIC WEAKNESS: The data has been weak across the board lately, reinforcing the view that the economy is already in recession. The housing sector has been contracting for two years, but the latest evidence suggests that the pain is spreading. U.S. retail sales fell 0.6 percent in February, a sign of the negative wealth effect from falling home prices. The labor market has been shrinking for two months, and jobless claims are holding at levels consistent with a broader growth slump. The New York Fed’s latest manufacturing survey posted its weakest reading ever, while national industrial output fell five times more than expected in February.
INFLATION, COMMODITIES: While controlling inflation is a key element of the Fed’s mandate, it seems to have been placed on hold for the moment on the expectation that weaker economic growth will restrain prices in the medium-term. Consumer prices have been rising above the central bank’s presumed 1 to 2 percent comfort range, even if they did stabilize in February. Moreover, record oil and commodity prices threaten the Fed’s forecast for continued price stability. Again, these issues are on the backburner for now, but are likely to re-emerge with a vengeance as soon as financial markets stabilize.
The recent tone of Fed officials has clearly shifted toward a broader acknowledgment of the serious nature of the credit crunch, indicating a greater willingness to continue easing monetary policy.
FED CHAIRMAN BEN BERNANKE, MARCH 16: “The Federal Reserve in close consultation with the Treasury is working to promote liquid, well-functioning financial markets, which are essential for economic growth. To that end we took two steps today. These steps will provide financial institutions with greater assurance of access to funds.”
NY FED PRESIDENT TIMOTHY GEITHNER, MARCH 6: “The U.S. economic and financial system is undergoing a very challenging period of adjustment, and we are likely to be living with a high degree of uncertainty for some period of time. If turbulent financial conditions and the associated downside risks to growth persist, monetary policy may have to remain accommodative for some time.”
Reporting by Pedro Nicolaci da Costa; Editing by Dan Grebler