Forecasts of the cut in the federal funds rate went up to 100 basis points; eventually, the cut came in at 75 basis points, higher than the earlier expectations of 50, but not quite living up to the Bear Stearns prelude.
Since this is highly unusual (the usual rate cut has been 25 basis points), it is significant in and of itself, but the growing possibility of more investment banks buckling under the weight of their hugely degraded portfolios raises serious questions about both the approach of the Fed in dealing with the situation and its ultimate effectiveness.
Indeed, questions have been asked as to whether the Fed is undermining the effectiveness of policy by being quite so panicky. The old critique of the utility of monetary policy in dealing with a recession -- it is like pushing on a string -- also comes to mind, but with a new and complicated twist.
In the textbook scheme of things, more money is supposed to bring down interest rates and stimulate investment and consumption spending. But for these things to happen, the financial system has to respond to the policy stimulus by bringing down its lending rates and pushing people to borrow more.
In today's circumstances, however, getting people to borrow more is the last thing on the minds of financial service providers. Most of them are reeling under the weight of assets whose prices have declined precipitously because nobody in his right mind wants to buy them.
As investors in these institutions rush to get their money out, their inability to liquidate these assets drives them to the brink of bankruptcy and the desperate search for rescue or takeover options, a la Bear Stearns.
Expansion of credit, in either the retail or wholesale segments, depends significantly on the ability of the lenders to pass these risks on through securitisation, credit default swaps and other market-based instruments.
It is these very markets that have stopped working, severely limiting the incentive that any lender has to expand his loan portfolio. In other words, lowering interest rates and infusing liquidity into the system are not going to work unless they translate into increased borrowing, which the financial system is in no position to guarantee.
Federal Reserve Chairman Ben Bernanke himself emphasised the limitations of monetary policy in his testimony to the US Congress a couple of months ago. He urged the legislators to quickly approve the fiscal stimulus package, which has since been done. This did increase confidence levels that the combined monetary-fiscal stimulus would confine the US economy to a shallow and short recession, but it now appears that the capacity of the financial system to transmit the stimulus to the economy was over-estimated.
As institutions fail, the nervousness of financial markets increases. Assets that were reasonably liquid suddenly become untouchable. This triggers a further sequence of bankruptcies. This is clearly the danger in store over the next few weeks and months, which no amount of liquidity infusion is likely to forestall.
The only visible solution is for governments to acquire degraded financial assets at something close to their fair value. The appetite for this measure on a large scale is yet to be articulated. It would, in effect, be a large loan waiver for the American financial system. Perhaps Mr Chidambaram has set a trend in motion!
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