The Fed's Thaw

By Allan Sloan
Tuesday, December 25, 2007

The Federal Reserve Board's clout isn't what it was during Alan Greenspan's glory days. Back then, the Fed looked and acted all-powerful (even though it wasn't). Now it's visibly failing to unfreeze key debt markets in which giant institutions lend to each other. Those markets have frozen out of fear: No one knows what hidden time bombs are on other firms' balance sheets, or even on their own. The Fed hasn't been able to thaw the markets with interest rate cuts or by using its discount window, through which it lends directly to institutions, and it has been reduced to trying to bribe and cajole big players into borrowing its money as a substitute for borrowing from each other.

It's not clear whether its recently created "term auction facility," designed to induce institutions to borrow from the Fed, will unfreeze things. The first two auctions were a blowout success. The Fed said it got about $3 in bids for each $1 offered, but I suspect that's because the auctions were for a relatively small $20 billion each and because the Fed and its allies jawboned institutions to bid.

Am I really saying that the Fed, which to many people still seems omniscient and omnipotent, has lost much of its mojo? I am. Why should you care? Because if the Fed continues to lose clout, it will be even harder than it is now to rescue the world's financial system when the next disaster strikes the markets. And there's always a next disaster.

The mojo minimization isn't all the Fed's fault, of course. The United States has become less dominant financially, thus reducing the Fed's global influence. Meanwhile, markets have become enormous and transnational and, thus, harder to influence.

Part of the problem is of the Fed's own making. Its power has always depended more on its reputation than on its actual resources. The Fed lost credibility for not trying to pop the stock bubble of the 1990s or the recent housing bubble; it obsessed about nonexistent deflation; it even (unintentionally) exacerbated the housing bubble by not stopping institutions it regulates from offering dangerous products, such as "liar's loans" and the teaser-rate mortgages that now plague the financial system. Finally, it keeps bailing out the enablers of financial excess while penalizing prudent Americans by reducing the rates that their savings earn and accelerating the dollar's decline relative to commodities and foreign currencies.

Then there's Greenspan, appropriately sphinx-like during his two decades as Fed chairman, who these days has become almost a babbler, running around promoting his book and trying to protect his legacy by blaming today's problems on everything and everyone but himself. He's turned himself from an icon into a target, which isn't helping the Fed's reputation. It's sad to see, like watching a god descend from Mount Olympus to mud-wrestle with the plebes. As a friend of mine (who's not involved in any of this) quipped, "They ought to go back to the days when they were more of a Delphic oracle. The problem with transparency is that people see through it."

During its opaque days, the Fed used its discount window to lend to institutions that needed short-term money. But the Fed has allowed the window to fall into disrepute; window borrowers are perceived as desperate, so institutions don't want to use it. This past summer, the Fed tried to get borrowers that didn't need the money to come to the window to set an example. However, that didn't catch on.

The auction facility is a clever idea, and involving other central banks, as the Fed has done, is very smart. But there's still a problem: If borrowing at the Fed discount window carries a taint, then why wouldn't borrowing at the Fed auction, which players know is window lite, carry a taint, too?

Answer: The Fed hopes that greed (the first auctions' money cost 4.65 percent and 4.67 percent, below the window's 4.75 percent) and animal spirits (who can resist trying to win an auction?) will attract so many bidders there will be no taint on the TAF, as the term auction facility is known. The idea is to keep things going until institution-to-institution markets unfreeze. Perhaps the Fed can use the TAF to replace the window. Will it work? Who knows?

Maybe I'm getting soft on the Fed, which I've treated less than reverentially for years. But I sure hope this facility -- or something -- stabilizes the markets. It's creepy out there. If the Fed can get debt markets working again, maybe it can regain its golden glow. And if it starts to act the way it should -- swiftly, secretively, and effectively -- maybe it will get to keep it.

Allan Sloan is Fortune magazine's senior editor at large. His e-mail address isasloan@

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