Friday’s intervention

I suppose it has been a long time since the Federal Reserve Board last changed rates of any kind “off-schedule,” that is, between its regular meetings, so Friday morning’s announcement from the Fed that it was lowering the discount rate was something of a shock for nearly everyone. Woe to the investor who entered Friday holding large short positions, because the Fed’s rare move sent the market significantly higher—the Dow ended Friday 233 points (1.82%) higher, the S&P nearly 2½ percent higher. In the days since the last Fed meeting, where the Board left the federal funds rate unchanged, we have seen the Fed increase liquidity levels in the system; now we have a relatively rare rate change out of the blue…clearly, the Fed’s confidence in the stability of the greater economy has deteriorated.

I don’t envy Chairman Ben Bernanke. He is in a tough position, pulled in opposite directions at the same time. Despite encouraging recent data, inflation remains a very real concern and has been traditionally the Fed’s chief enemy. Combating inflation means taking liquidity out of the system, but the credit markets’ recent seizure forced upon the Fed the decision to open the flood gates and allow more money to flow.

A short-term fix, yes, and we will likely see just how short next week. Besides adding more liquidity to the market, the Fed’s decision will likely revive the old notion of moral hazard. If there is no pain to endure as a consequence of bad decision-making, then bad decisions will likely be made more often. This is how economic molehills become mountains.

Conversely, the only other option available to Bernanke is to play chicken with the train of events set in motion. Until today, we had a stock market that had posted six straight losing sessions; we had a situation where (seemingly) no amount of lubricant could unstick the credit markets’ gears; we had a mortgage market where even high-quality borrowers could not secure credit. We had an interbank market where banks refused to lend to one another. How far would all of this go? We may well find out despite the Fed’s actions, and perhaps it is necessary to find out…up to a point. But if the Fed were to allow things to play out without intervening, there is no guarantee we could arrest events if things were to deteriorate rapidly. Right down, we’re merely sliding down the mountain, not tumbling head over heels.

Time will tell if this intervention was warranted or whether it made matters worse.