Fed to try another way of injecting banks with cash

By Krishna Guha and Michael Mackenzie
Financial Times, London
Tuesday, December 11, 2007

http://www.ft.com/cms/s/0/6bcfd8ee-a80d-11dc-9485-0000779fd2ac.html

The Federal Reserve is set to overhaul the way it provides liquidity support to financial markets, following a negative reaction to Tuesday’s interest rate cut.

US stocks fell sharply after the central bank cut rates by only 25 basis points to 4.25 per cent and failed to offer a clear signal of more to come.

The overhaul, which could be announced as early as Wednesday, is likely to take the shape of a new liquidity facility that will auction loans to banks. This would allow the Fed to provide liquidity directly to a large number of financial institutions against a wide range of collateral without the stigma of its existing discount window loans.

The idea is that this would ease severe strains in the market for interbank loans, and help restore more normal conditions in credit markets generally.

However, it is unclear whether the new initiative will win over investors disappointed by Tuesday's announcement. Many had hoped for a 50bp cut in the main interest rate, or at least a 50bp reduction in the discount rate, and a stronger indication of further cuts in the pipeline.

Dominic Konstam, head of interest rate strategy at Credit Suisse, said: "The Fed disappointed the market in lots of ways."

The S&P 500 closed down 2.5 per cent at 1,477.65, after being up 0.4 per cent before the decision was released. The yield on the two-year Treasury note was at 2.92 per cent, down from 3.14 per cent.

The selloff spread to Asia and Europe on Wednesday. Shares in Hong Kong led the retreat, with the Hang Seng index falling 705.78 points or 2.4 per cent to 28,521.06, while the Nikkei 225 slumped 112.46 points or 0.7 per cent to 15,932.26.

In Europe, banks and companies with heavy US exposure led fallers. The FTSE 100 was down 61.6 points or nearly 1 per cent, while the Dax 30 shed 48.51 points or 0.6 per cent to 7,960.91. The CAC 40 in Paris fell 64.96 or 1.1 per cent to 5,659.80.

The Fed said the deterioration in financial market conditions had "increased the uncertainty surrounding the outlook for economic growth and inflation."

But while it dropped its assessment that the risks to growth and inflation are "roughly balanced," the Fed did not say that it now thinks the risks to growth outweigh the risks to inflation.

It offered no assessment of the balance of risks, saying it would act "as needed" to foster price stability and sustainable economic growth. This formula in effect means the Fed is keeping its options open.

Investors could infer a willingness to consider future rate cuts, but the signal was weaker than many had expected. This reflects the fact that the Fed remains more concerned about the risks to inflation than most investors.

The Fed said "incoming information suggests that economic growth is slowing," reflecting an "intensification of the housing correction" and "some softening in business and consumer spending." It acknowledged that "strains in financial markets have increased in recent weeks."

However, the US central bank made almost no changes at all to its language on inflation, reiterating that "energy and commodity prices, among other factors, may put upward pressure on inflation."

Eric Rosengren, a committee member and president of the Boston Fed, dissented in favour of a 50bp cut. At the last meeting, Tom Hoenig, president of the Kansas City Fed, dissented in favour of no cut.

Money market traders had earlier priced in a decline in Libor when it sets on Wednesday. Later, those expectations reversed and one-month Libor is seen at 5.21 per cent on Wednesday, up from an estimate of 4.96 per cent and above Tuesday’s setting of 5.20 per cent.

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