Why the worlds central banks (including the Fed) can’t save the markets

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Financial markets are disintegrating around the world. Professionals and regular investors are seeing red all over the screens and portfolio values are dropping faster than during the dot.com bubble burst or after the September 11 terrorist attacks. Central banks (which includes the federal and reserve banks) around the world, along with governments, are trying to stem the tide – but to no avail. In fact their actions are making investors more nervous and thereby making things worse. Big interest cuts will provide a temporary relief, but the downward momentum will continue.

So what is the cause of this downward momentum? Fear. Plain and simple. Until investor fears are appeased, nothing will stop the deterioration in financial markets. “It doesn’t address the fundamental problems, which is that financial markets are just scared,” said David Wyss, Standard & Poor’s chief economist. “The Fed is trying, but they don’t have a magic wand to wave and make everyone confident again.”

Some argue that the US Federal reserve is feeding current market fears with emergency moves like bailing out Bear Stearns and the decision to make loans directly to Wall Street firms instead of just banks. “Anytime you act on a Sunday night during ’60 Minutes,’ (like the Fed did) if you don’t think that will engender fear, I don’t know what does,” said an analyst. “The market is going to stay worried, regardless of what the Fed and other central bank actions. Currently the market is betting It’s heads you lose, tails you lose.”

But Lyle Gramley, a Fed governor from 1980 to 1985 and now a senior economic advisor for the Stanford Washington Research Group, said that such a failure would have far broader implications for the economy and the financial markets and the Fed has to do what it can to avoid that. “If the Fed had sat aside and let Bear go down the tubes, the cascading effects would have been ghastly,” he said. Still, Gramley concedes the Fed has only a limited ability to deal with market fears. And he said that makes this economic crisis the most difficult challenge for the central bank since the Great Depression. “In all past recessions, I was always quite sure that if the Fed stomped hard on the gas pedal, the economy would turn around and start to grow,” he said. “But they’ve now stomped hard on the gas, and credit is not more available, it’s less available.”

Gramley and some other experts believe the solution to the current credit crisis will have to come from Congress, not the Fed, and that the federal government will have to take steps to bail out both Wall Street firms holding mortgage-backed securities as well as homeowners who have mortgages with balances greater than the value of their homes. Evidence of this can be seen with the recent announcements by the housing department to provide assistance to owners facing foreclosure (Hope for Homeowners program)

But many others think the Fed has no choice but to keep slashing rates. “It helps, even if it doesn’t solve the problem,” said Wyss. “You need to keep the cost of borrowing down. It’s not the optimal solution, but it’s better than nothing.” And no matter what the Fed does, market fears probably won’t go away any time soon. After all, some investors will probably take more Fed cuts as a sign that the central bank sees more trouble ahead.

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