Fed gives no hint it plans to bail out lenders

John W. Schoen Senior Producer • Profile • E-mail

After weeks of turmoil in the stock and bond markets, the Federal Reserve Tuesday held tough, offering little indication that it was in the mood to help bail out lenders and investors who have been hit with steep losses.

The central bankers left short-term interest rates unchanged and said in its public comments that the threat of inflation remains uppermost in its policy deliberations.

The statement from the Federal Open Market Committee made note of the ongoing turmoil in the financial markets, the mortgage mess and the tightening of credit. Still, the Fed’s judgment is that those forces don’t pose an immediate threat to the U.S. economy.

"Although the downside risks to growth have increased somewhat, the committee's predominant policy concern remains the risk that inflation will fail to moderate as expected," the central bank said in a statement.

The rate decision extended a year-long policy of leaving short-term interest rates rock steady at 5.25 percent and maintaining a tough stance on inflation.

With billions of dollars worth of paper going up in smoke on the bond market, some on Wall Street had been hoping that Fed policy makers would change its inflation-fighting “bias” in favor of a “neutral” stance — a possible harbinger of lower interest rates to help make credit more available. The Fed acknowledged that it was watching the slumping housing market and fallout from easy-money loans gone bad.

"Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing," the FOMC said.

"Volatile" is putting it mildly. Investors were paying close attention to what had been expected to be a sleepy summer meeting of the Fed after the stock market's recent violent gyrations — down 300 points one session and up 300 the next. The volatility reflects growing uncertainty over the extent of the damage from risky borrowing and the impact on the economy.

The market continued seesawing Tuesday after the Fed's statement, with the Dow first dropping more than 100 points than jumping more than 100 points before ending the session with a gain of 35 points.

Nobody yet knows how much further the fallout will spread from the housing market downturn, but if banks and investors overcorrect by clamping down on credit, a recession — although considered unlikely — is a possibility.

But with inflation still running a bit hotter than the Fed’s comfort level, and the economy still moving along at a respectable pace, the central bank gave no indication that it plans to cut rates to bail out the sagging housing market or calm or holders of bad loans.

The end of easy money
In recent weeks, the meltdown in the subprime mortgage market has spread to the broader bond market. Home buyers with shaky credit weren’t the only ones affected by the credit bubble that is now unwinding. Hedge funds and other professional money managers snapped up bonds at bargain interest rates, helping fuel the biggest buyout boom since the junk bond mania of the 1980s.

Now, as many of the mortgages supporting those bonds have gone bust, and bankers are backing away from financing new mega-buyouts, money has suddenly gotten a lot more expensive. The rise in market interest rates — and the evaporation of demand for some of these riskier bonds — has left many bond holders with big losses. And the shift in psychology from the days of easy money to fears about credit risk have come faster than even the worst-case scenarios suggested by Wall Street’s computer models.

While home buyers who overborrowed and investors who bought risky bonds are feeling the brunt of the impact, the broader economy has held up relatively well. After sputtering in the first quarter of the year, the Gross Domestic Product expanded by 3.4 percent in the second quarter. 

That growth seems to be slowing; job growth in July was a bit weaker than expected and many forecasters are looking for slower growth through the second half. While the housing slump and the shakeout in the credit markets brings the risk of recession, most private economist still say the odds are the economy will avoid a downturn.

The Fed seems to agree — for now — saying “the economy seems likely to continue to expand at a moderate pace over coming quarters."

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