The Fed's Dilemma
By: Mark Zandi
Written September 3, 1998   

The slide in global financial markets is resulting in increasingly urgent calls on the Federal Reserve to ease U.S. monetary policy. Economists and policymakers of all stripes are asking the Fed to meet its responsibility as the financial system's lender of last resort. Financial markets are expecting the Fed to move soon. Bond yields have fallen below the current funds rate of 5.5%, and the funds rate implied on federal funds futures contracts that expire early next year is close to 5%.

Financial institutions from Bankers Trust to Morgan Stanley are indeed reporting hundreds of millions of dollars in trading losses, primarily due to their trading activities in Russia and other emerging markets. The concern is that these mounting losses will prompt a crisis of confidence among lenders resulting in the failure of what may be a solvent institution due to a lack of liquidity. The failure of one such institution could then induce a chain reaction among many other institutions with which it does business. The entire financial system could come to a grinding halt. This in many regards is what has happened in Asia, exacerbating what could have been a modest downturn into what is arguably a depression.

The Federal Reserve is rarely called upon to perform its function as a lender of last resort. The last time being in the wake of the October 1987 stock market crash. The over 20% decline in the stock prices in one day was enough to put a number of financial institutions out of business. The nation's financial system was at risk of melting down and the Fed stepped in by providing significant liquidity. The federal funds rate plunged 100 basis points nearly overnight.

Why has the Fed failed to respond to the current global financial market sell-off? So far the Fed has resisted such calls, not even making an official or unofficial announcement of its readiness to provide liquidity to the financial system let alone lowering interest rates.

The answer lies in assessing the economy's performance in the three years following the 1987 stock market crash. The greater liquidity and lower rates provided by the Fed in response to the crash not only staved off a financial crisis, it helped to soon stimulate a much stronger economy. The Fed had to quickly reverse course and began quickly ratcheting up rates beginning in the spring of 1988. By early 1989 the funds rate had risen some 300 basis points to nearly 10%. High and quickly rising interest rates were soon too much for the economy to bear. The Northeast economy was in recession by mid-1989 and the rest of the economy followed by mid-1990.

The Fed had no choice in easing interest rates in response to the 1987 stock market crash. No action would have resulted in a more severe financial crisis and likely an economic downturn soon thereafter. The Fed's actions, however, were the principal factor contributing to the recession some three years later. The Fed would like to avoid such a scenario today.

Besides, while financial institutions are suffering significant losses as a result of recent events, no institution appears to be facing insolvency or lack of liquidity. The nation's banking system is very well capitalized. The equity-to-capital ratio for commercial banks is near an all-time record high of 8.5%. Financial intermediaries are also highly profitable despite the recent losses. Even with these losses, the return on assets for all commercial banks likely remains well over 1%. In the past anything over a 1% ROA was considered to be very profitable.

Policymakers, particularly Fed Chairman Alan Greenspan, may also be viewing recent events somewhat positively. The chairman has been warning about speculation in equity markets beginning with his 'irrational exuberance" speech of nearly two years ago. The Fed chairman also described last October's stock market decline as a "salutary event." Stock prices today are only back to where they were last October, and they are still well above the prices that prevailed two years ago. Lower stock prices could also take a little more steam out of the strongly growing economy with exceedingly tight labor markets.

The probability that the Fed will soon ease monetary policy has certainly risen considerably as a result of recent events. Another day or two of declines like those experienced recently could very well indeed push some institutions to the brink of bankruptcy and thus quickly call the Fed to action. Given what has happened to date, however, the chances the Fed will ease monetary policy in the next six months is still no better than fifty-fifty. If the Fed is forced to ease aggressively before year's end, then the risks that this economic expansion will come to an end will rise significantly--not in 1999, but in 2000.