Is Bernanke Tough Enough?

Aug. 21, 2007 — -- Wall Street is still feeling queasy from the roller coaster ride of the past two weeks, and financial analysts say it may be a few more weeks and months before investors regain solid footing.

Investors big and small, battered by the 4 percent drop in the Dow Jones industrial average since Aug. 9, are trying to figure out if the Fed's reduction in the discount rate is enough to counteract the lack of action in the credit markets.

"This will play out over time, and liquidity will return to normal when the market has a better understanding, investors have a better understanding, of the risk-return trade-off," said Treasury Secretary Hank Paulson in a morning interview on CNBC.

"Markets straighten themselves over time. This is going to take a while to play out," he said.

The professional money on Wall Street is hesitant to believe the worst is over, but last week's cut in the discount rate -- the rate of interest banks pay to borrow money from the Fed -- is a strong hint to traders that more Fed action is on the way.

"I don't think it rallied strictly because there was a 50-basis-point cut in the discount rate," said Joel Naroff, economist and founder of Naroff Economic Advisors. "The markets are expecting the Fed to cut the funds rate, and probably cut the funds rate fairly significantly by the end of this year. That's really what we may need to see happen."

In recent years, the Federal Reserve has made it a policy not to change the Fed Funds rate -- a key in determining the interest rates for all kinds of short-term credit vehicles -- between its regularly scheduled meetings. The next time the Fed is scheduled to meet is 20 trading days away on Sept. 18.

"This is a proud Fed. But for my money, the discussion they had at the time of the discount rate cut was sufficient to say, these were grounds to cut the [Fed] funds rate," said Bob Brusca, economist at Fact and Opinion Economics. "In my mind, the only reason the Fed didn't cut the funds rate was because they had this silly rule saying they wouldn't except at meetings."

Smaller Risk, Guaranteed Return

Why would more Fed action be needed? There is still no real appetite for corporate bonds, and money managers are making a run on short-term U.S. treasuries, an investment that offers a smaller interest rate but a guaranteed return.

This so-called "flight to quality" is seen by many analysts as a sure sign that the credit crunch is not yet over. And while the stock market ended up posting two positive sessions on Friday and Monday, many people believe the downturn is far from over.

"It's important to be vigilant but also it's time to act," said Sen. Christopher Dodd, D-Conn., head of the Senate Banking Committee, at a press conference this morning.

Dodd said that during a meeting with Fed Chairman Bernanke and Secretary Paulson he encouraged the nation's central bank to use all the tools it has at its disposal to eliminate the problems in the credit markets.

"I just don't think that holding out is a good idea at all, because it's a month away," said Brusca. "So are we gonna just sit here and drum our fingers for the next month and say 'The Fed's coming, the Fed's coming?'"

Many analysts say they don't expect a move in the Fed Funds rate before the scheduled September meeting. They say it would take a significant crisis to prompt action before then.

"The Fed will probably be prepared to cut the rate not just in September, but continuously until they're very confident that whatever credit constraints that are out there have disappeared," said Naroff. "This could be a process that could take us through the end of this year."