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FOMC keeps its cool, but rescue of AIG clouds the decision

Wed, Sep 17 2008, 07:16 GMT
by KBC Market Research Desk

KBC Bank

• • United FOMC keeps rates unchanged despite signs of extreme stress in markets….
  
• • .....concentrating on the growth and inflation outlook ....
  
• • .....and apparently adressing financial stress by other means ....
  
• • .....FOMC gamble succeeds as markets react positively, but
  
• • ....overnight the Fed actually bailed out AIG….

The FOMC decided to keep its rates unchanged at a tense meeting and against market pressure. However, its attitude may have been influenced by its decision barely 6 hours later to bail out AIG for an amount of $ 85 billion.

· Separate monetary policy decisions and financial stability

The FOMC decided for the third consecutive meeting to keep rates unchanged at 2% in what should have been a very tense and hotly debated meeting. Indeed, the bankrupcy of Lehman over the weekend and the problems of amongst others AIG led to shockwaves in financial markets amid fears for a meltdown. Stocks looked into the abyss on Monday when the S&P dropped 4.7%, the steepest one-day loss since 9/11.

It is very telling that the FOMC statement barely mentioned the financial and systemic problems. Only the fact that NY Fed governor Geithner stayed in New York to work on a solution for the AIG (and other) problems reminded observers that it wasn’t business as usual. Mr. Geithner was replaced by Ms. Cumming.

The FOMC conveys the message that it wants to separate its dual mandate of maximal sustainable growth and price stability from its duty as safeguard of financial stability. In this respect, the FOMC decision re-inforces its attitude in the Lehman affair, where it (and the Treasury) drew the line under the too big too fail doctrine and restored the moral hazard principle. A rate cut yesterday could have been seen as the Fed retreating from these principles. At the Jackson Hole conference, the Fed got extensive critique for the aggressive easing of policy in early 2008 which was clearly done for financial stability reasons more than for economic ones. After the till now latest rate cut, notably in late April, the Fed signalled that it had probably finished with its easing cycle and explicitly stated that some further worsening worsening of the economy wouldn’t force them to cut rates further, given their earlier aggressiveness. The steep rise in inflation in spring and early summer led to a near revolte of a number of regional Fed governors who had before resisted the policy of aggressive easing of chairman Bernanke.

In this sense, the unanimous decision to keep rate unchanged yesterday, Dallas Fed governor Fisher rejoined the majority, signals that the divisions inside the FOMC are healed. Unity is an important asset for the Fed in turbulent times.

Overnight, six hours after the FOMC decision, the Federal Reserve Board (don’t mix up with the FOMC), with the support of the Treasury, authorized the NY Fed to lend up to $85 billion to AIG. The statement said that a disorderly failure of AIG could add to the significant levels of financial stress and lead to higher borrowing costs and weaker economic performance. The loan is accorded under (severe) conditions (cf. below), also to protect interests of taxpayers, and the government receives a 79.9% stake in equity interest in the company, giving it the authority to block the payment of dividends to common and preferred shareholders. The objective seems to be an orderly downscaling of the firm (sale of assets) and may even lead to the end of the operations of the biggest insurer.

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Published on  Wed, Sep 17 2008, 07:27 GMT