Amid Turmoil, Fed Holds Steady

By Nell Henderson and Tomoeh Murakami Tse
Washington Post Staff Writers
Wednesday, August 8, 2007

Stock prices are swinging. Credit is tightening. And the deepening housing market downturn has increased the risks of a recession.

But Federal Reserve officials yesterday declined to come to the rescue.

The Fed's top policymakers acknowledged the recent turmoil in financial markets, but held its benchmark short-term interest rate steady at 5.25 percent, saying in a statement that the economy would weather this storm without their help.

"The Fed is plainly in no hurry to bail this market out," said Alan Ruskin, chief international strategist at RBS Greenwich Capital of Greenwich, Conn. "The Fed has probably done enough to show they are not asleep at the wheel. The question is whether this market demands more active steer."

That is the question confronting Fed Chairman Ben S. Bernanke as he faces the most severe financial market turbulence since he succeeded Alan Greenspan in February 2006.

"This is Bernanke's first test," said Diane Swonk, chief economist at Mesirow Financial, a privately held investment management and advisory firm in Chicago. She said the Fed chief has managed it well so far, but has done so in sharp contrast to Greenspan's more aggressive efforts to steady jittery markets. "The Bernanke Fed is more academic in their approach to monetary policy, in that they are much more reluctant to second-guess financial markets than Greenspan, who was closer to financial markets. It's very ironic."

The Fed's rosy outlook was rejected yesterday by some analysts. "It goes to show you the drunken state of the stock market these days, where we have these massive problems in real estate and structured credit, and they decide to go crazy because the Fed says in essence, 'Everything is okay,' " said Bill Fleckenstein, president of the Fleckenstein Capital hedge fund in Seattle. "I think the Fed is mistaken."

Stocks fell initially after the Fed's statement dashed hopes the central bank would soon slash interest rates. They bounced back, however, after investors realized the Fed's statement offered reassurance that policymakers were monitoring market developments and Fed officials did not see signs of a crisis requiring their intervention.

Stock prices ended the day slightly higher. The Dow Jones industrial average of blue chip stocks rose 35.52 points, or 0.3 percent, to 13504.30. The Standard & Poor's 500-stock index advanced 9.04, or 0.6 percent, to 1476.71. The tech-heavy Nasdaq rose 14.27, or 0.6 percent, to 2561.60.

Stock prices have fallen sharply in recent weeks as credit has tightened for many home buyers and business borrowers. Rising mortgage defaults have caused Wall Street investors to stop buying many securities backed by home loans, thus shutting off the flow of money that had financed much of the housing boom. Dozens of mortgage lenders and at least two hedge funds have shut down, while companies in other industries have shelved plans to borrow money.

Home buyers are finding it virtually impossible to obtain mortgages unless they are willing to document their income, make sizable down payments and demonstrate a history of paying bills on time -- a drastic shift from the looser borrowing rules of recent years.

Even borrowers with good credit histories have seen mortgage interest rates jump on "jumbo loans" worth more than $417,000. Such loans were used heavily in the Washington area and other regions where home prices soared during the boom.

Many investors and analysts had hoped the Fed might respond to the lending crunch by pumping more money into the financial system by easing the key short-term interest rate. Instead, the central bank's top policymaking group, the Federal Open Market Committee, voted unanimously to leave the benchmark rate unchanged at 5.25 percent, where it has been for more than a year. The rate influences other short-term rates, including those on credit cards and many business loans.

Fed officials, in their statement, acknowledged the recent market developments and said they see increased risk that economic growth could sputter. For now, though, they said they do not see a recession looming.

"The economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy," the group said. And with unemployment at a low 4.6 percent, they said they also remain more worried about inflationary pressures.

Many investors had pinned their hopes for a rate cut on memories of how the Fed slashed borrowing costs in the fall of 1998 when credit markets seized up after Russia's debt default and the near-collapse of a big hedge fund.

The Fed, then led by Greenspan, also responded to the recession and terrorist attacks in 2001 by aggressively lowering interest rates to increase spending. The central bank kept cutting its benchmark rate until it reached a four-decade low of 1 percent in mid-2003, and held it there for a year.

The Fed's responsiveness led many investors to expect the central bank would cut interest rates any time the markets swooned, an idea called "the Greenspan put." In finance, a "put" is a contract that guarantees that an investor will get no less than a certain price for a stock, bond or other asset by putting a floor under falling prices.

Fed officials prefer not to intervene in financial markets unless necessary to keep the system functioning. Absent a crisis, the Fed would prefer to let the credit markets sort themselves out.

"The Bernanke Fed's mandate does not include bailing out speculators," said Richard A. Yamarone, director of economic research at Argus Research in New York. "When you are a hedge fund investor, you sign papers saying, 'I am a very wealthy investor and I'm prepared to take big risks and lose money.' "

Yamarone is among many analysts who said the credit-market correction was necessary after the lending excesses fueled by too many years of easy money. In this view, the Fed was right to cut borrowing costs earlier in this decade.

Yamarone said, however, that "Greenspan and Co. should have pulled back on the reins a little sooner than they did, and maybe lifted rates a little higher, too."

Tse reported from New York.

© 2007 The Washington Post Company