- The Washington Times - Saturday, March 22, 2008

From carpet-bombing the Texas airwaves with her “red-phone” ad to accusing Barack Obama of plagiarizing his speeches, Hillary Clinton was said to have tossed “the kitchen sink” at her opponent in her desperate, and successful, efforts to win the Texas and Ohio primaries earlier this month. However, when it comes to throwing everything, including “the kitchen sink,” at a problem, Mrs. Clinton is a piker compared to Federal Reserve Chairman Ben Bernanke, who, despite being relatively far more aggressive in attacking his problem (the worsening economic crisis afflicting the financial, credit and housing markets), has far less to show for his efforts than she does for hers.

Reacting to the early summer implosion of two Bear Stearns hedge funds caught in the subprime-mortgage debacle, financial and credit markets first seized up in August. The seizure manifested itself through a soaring TED spread, which is the difference between the interest rate on three-month Treasury bills and the rate that banks charge each other for three-month loans. From comfortably below 0.5 percentage points, the TED spread jumped to nearly 2.5 percentage points in August. Markets settled down a bit in September and October. But panic returned in November, when the TED spread exceeded 2 points before retreating below 1 point early this year. In recent weeks, as the third wave of the financial crisis erupted, the TED spread once again headed toward 2 points as financial intermediaries raced toward the safety of T-bills and away from the feared insolvency of their fellow bankers.

In terms of the potential impact on the U.S. economy and its financial markets and judged by how aggressively the Fed has felt compelled to act, today’s problems make the 1997-98 Asian financial crisis (including the related implosion of the Long Term Capital Management hedge fund and Russia’s momentous default) look like a walk in the park. After absorbing numerous attacks, today the U.S. financial system is in its most vulnerable condition since the crisis erupted last summer. Many economists believe the crisis in the financial, credit and housing markets will prove to be the worst since the Great Depression.

To appreciate the relative magnitude of the challenge confronting the Fed today compared to the indisputably serious problems posed by the Asian crisis, let’s review how the Fed reacted to both by reducing its benchmark interest rate — the so-called federal-funds rate, which is the interest rate banks charge each other for mostly overnight loans.

Although the Asian crisis erupted in the summer of 1997, the Fed did not adjust the fed-funds rate until late September 1998, when it lowered it a quarter-percentage point to 5.25 percent. In an emergency meeting convened Oct. 15, the Fed lowered its target rate by another quarter point. At its next scheduled meeting on Nov. 17, the Fed administered its third and final quarter-point cut, lowering its benchmark rate to 4.75 percent. Worth noting is that the 12-month consumer-price inflation rate held steady at 1.5 percent during this period. That means that as the nominal rate was lowered from 5.5 percent to 4.75 percent, the inflation-adjusted fed-funds rate fell from 4 percent to 3.25 percent.

During the current crisis, after it became apparent that the chaos in the financial and credit markets was affecting the real economy (this occurred when the first estimate of August payroll employment showed a reduction of jobs), the Fed lowered the fed-funds rate at its Sept. 18 meeting by half a point to 4.75 percent. At the time, the 12-month inflation rate was 2 percent. That cut was followed by quarter-point reductions at the Fed’s regularly scheduled Oct. 31 and Dec. 11 meetings. At an emergency meeting on Jan. 22, after foreign stock markets had plunged overnight, the Fed lowered its benchmark rate to 3.5 percent — even though the 12-month inflation rate had averaged 4.2 percent in November and December. Thus, the inflation-adjusted fed-funds rate moved into negative territory. Eight days later, the Fed knocked another half-point off its target rate. In less than 20 weeks, the Fed had lowered the fed-funds rate from 5.25 percent to 3 percent, even as the inflation rate had jumped from 2 percent to 4.2 percent.

On March 18, six months after it began reducing short-term rates, the Fed lowered its target rate another three-quarters of a point to 2.25 percent, even as the 12-month inflation rate stood at 4 percent in February. Thus, while the Fed had lowered the nominal fed-funds rate by 3 percentage points over six months (from 5.25 percent to 2.25 percent), the inflation-adjusted fed-funds rate actually plunged by 5 percentage points, falling from a positive 3.25 percent in September to a negative 1.75 percent today.

Not since the early 1980s had the Fed lowered its target rate by three-quarters of a point in a single move. Now, in the span of less than two months this year, it had done so twice. And the financial markets are still reeling. Moreover, recall that the Fed had responded to the Asian financial crisis in 1998 by reducing the inflation-adjusted fed-funds rate by three-quarters of a point and lowering it to a positive 3.25 percent. In the current crisis, in which the economy, if it has not already done so, will almost certainly fall into recession, the Fed has already reduced the inflation-adjusted fed-funds rate by 5 percentage points and lowered it to a negative 1.75 percent.

Beyond slashing the fed-funds rate, the Fed has been engaged in extraordinary policymaking since the markets first seized up in August. Those historic moves will be detailed and examined in a forthcoming editorial.

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