Stocks soared Wednesday after Federal Reserve Vice Chairman Donald Kohn said the Fed must be “nimble” in responding to turmoil in financial markets to preserve access to loans for consumers and businesses.
Investors interpreted Kohn’s comments as a sign that the Federal Reserve will cut short-term interest rates when it meets on Dec. 11, although Kohn said the views he expressed were his own.
In a speech to the Council on Foreign Relations in New York City, Kohn said that while he’s aware of the “moral hazard” of attempting to alleviate the pain of troubled homeowners by cutting interest rates, there are larger economic issues at stake.
“To be sure, lowering interest rates to keep the economy on an even keel when adverse financial market developments occur will reduce the penalty incurred by some people who exercised poor judgment,” Kohn said. “But these people are still bearing the costs of their decisions and we should not hold the economy hostage to teach a small segment of the population a lesson.”
On Oct. 31, the Fed lowered its target rate for the federal funds rate to 4.5 percent and cut the discount rate to 5 percent. The federal funds rate is the rate banks charge each other for overnight loans, while the discount rate is the rate the Fed charges for direct loans to banks.
On Sept. 18, the Fed took even more drastic action, slashing 50 basis points of both key short term rates.
Although reducing short-term interest rates can stimulate economic growth by encouraging borrowing, the Fed has to weigh those benefits against potential consequences such as weakening of the dollar and inflation.
Kohn said an important factor when considering further cuts is whether concerns about losses on mortgages and other investments backed by loans are constricting the flow of credit to a broad range of borrowers.
But fears of losses on mortgage loans persist, and that’s reduced the availability of new mortgage loans, he said. That, in turn has reduced the demand for housing and put downward pressures on house prices, further damping the desire to lend.
“We are following this trajectory closely, but key questions for central banks, including the Federal Reserve, are, ‘What is happening to credit for other uses, and how much restraint are financial market developments likely to exert on demands outside the housing sector?’ ” Kohn said.
After a period of turmoil in August — when lenders like Countrywide Financial Corp. were suddenly unable to finance their operations by issuing short-term “commercial paper” debt — financial markets showed some signs of a return to normalcy.
But the increased turbulence of recent weeks “partly reversed some of the improvement in market functioning over the late part of September and in October,” Kohn said. “Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses. Heightened concerns about larger losses at financial institutions now reflected in various markets have depressed equity prices and could induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses a well.”
Kohn said that while cutting the discount rate reduces the cost for banks to borrow directly from the Fed, there is a stigma attached to using the “discount window,” because banks fears that doing so “might be mistaken for accessing emergency loans for troubled institutions.”
“The success of such a program lies not in loans extended but rather in the extent to which the existence of this facility helps reassure market participants,” Kohn said. “In that regard, I think we had some success, at least for a time.”
As for the federal funds rate, Kohn said term interbank funding markets remain unsettled. Rates like LIBOR — the London Interbank Offered Rate, often used to determine rates on adjustable-rate mortgages — have maintained a wide “spread” relative to the federal funds rate.
“Many loans are priced off of these term funding rates, and the wider spreads are one development we have factored into our easing actions,” Kohn said.
Kohn said uncertainties about the economic outlook are “unusually high right now,” requiring “flexible and pragmatic policymaking” from the Fed.
“Nimble is the adjective I used a few weeks ago,” Kohn said. “In the conduct of monetary policy, as Chairman Bernanke has emphasized, we will act as needed to foster both price stability and full employment.”