Rate cuts 'not to bail out Wall Street', says Fed official

Recent rate cuts by the US Federal Reserve were not intended to bail out investment banks hit by record write-downs in the third quarter, according to a senior Fed official.

Speaking at this year's annual Risk USA conference in New York in early November, Federal Reserve governor Frederic Mishkin insisted the decision to cut rates twice since September was taken purely to buoy the national economy, rather than help bolster the balance sheets of beleaguered investment banks hit by exposures to subprime mortgage loans.

"Our policies are designed to help Main Street and not to bail out Wall Street. Pursuing such policies does help financial markets recover from episodes of financial instability and can help lift asset prices. But this does not mean market participants who have been overly optimistic about their assessment of risk don't pay a high price for their mistakes - they have," Mishkin said.

The Federal Open Market Committee (FOMC) lowered its federal funds rate by 50 basis points to 4.75% on September 18 - the first cut since June 2003. It followed this with a further 25bp cut on October 31, despite concerns in some quarters about possible inflationary pressures from a weak dollar and rising oil prices.

"Monetary policy cannot have much influence on valuation risk, but it can address macroeconomic risk," Mishkin said. "The cut of 50bp at the September meeting was the most prudent action from a macroeconomic standpoint, and it should be clear at this point that the FOMC's decision was made purely on macroeconomic grounds - that is, policy was eased solely to offset macroeconomic risk."

Nonetheless, Mishkin conceded that the FOMC "perhaps could have waited for more clarity and left policy unchanged" in October. "But I believe the potential costs of inaction outweighed the benefits, especially because, should the easing eventually appear to have been unnecessary, it could be removed," he added.

In fact, it looks increasingly likely the Fed will cut rates again in December, despite earlier comments from Fed officials that appeared to pour cold water on a further easing. Speaking at a meeting of the Institute of International Finance in October, Fed governor Randall Kroszner said: "The current stance of monetary policy should help the economy get through the rough patch during the next year."

Meanwhile, Mishkin threw his support behind the proposals for the Master Liquidity Enhancement Conduit, the so-called 'super-conduit' planned by Citigroup, Bank of America and JP Morgan (Risk November 2007, page 8).1 "If the super-conduit brings more information into the financial markets, I think it will be beneficial, although I don't know enough about it at this time to say whether that will be the case," Mishkin said.

Peter Madigan.

1. www.risk.net/public/showPage.html?page=480622