US heads for recession as Fed ‘pushes on a string’

The Fed - along with other central banks - is to pump money into the banking system in order to ease the credit squeeze. How exactly will this work? And can it really help?

Stockmarkets had a roller-coaster week. Investors had been hoping for aggressive action from the Federal Reserve to shore up a US economy hit by the credit squeeze and the deepening housing slump.

But on Tuesday the US central bank only produced a quarter-point interest-rate cut to 4.25%, rather than the half-point cut many had hoped for. It said this should promote moderate growth "over time", while warning that "some inflation risks remain", suggesting that no more relief would be forthcoming. Anxious investors wiped 2.5% off the S&P 500 after the Fed's move.

But stocks rebounded rapidly on Wednesday when the Fed announced it was joining with four other central banks, the Bank of England, the European Central Bank, the Bank of Canada and the Swiss National Bank, to pump money into the banking system and thus try to ease the credit squeeze by reducing the rate at which banks lend money to each other, which has remained high despite rate cuts in the UK and the US.

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How will this work?

The Fed plans to auction off at least $40bn in four separate auctions this month, said the Wall Street Journal. The loans will be at lower rates than those charged on loans from the Fed's "discount window" (an emergency lending facility which charges banks a premium to the base rate), but will accept the same wide range of collateral as the discount window. In other words, it will give banks wider access to funds on easier terms all without the stigma of going to the emergency lending window.

Can it really help?

Markets certainly reacted positively, but it remains to be seen whether banks will take up the offer or not and more importantly, whether this cheaper credit will then be passed onto consumers. The trouble is that the Fed can make money cheaper but it can't force lenders to lend it or borrowers to borrow it; the Bank ends up "pushing on a string". This is particularly the case now.

Uncertainty over the extent of subprime exposure has caused banks to lose confidence in each other and in their own balance sheets and no wonder. This week, UBS wrote off another $10bn, even though an earlier $3bn hit was supposed to address the subprime problem. The resulting drive to preserve capital rather than lend to each other has fuelled a general clampdown on lending.

"The last real estate crisis and credit crunch" in 1990-1991 showed that there was no real "silver bullet" to combat lower credit availability after a long period of credit excess, as David Rosenberg of Merrill Lynch put it. It remains to be seen whether this latest move can stave off recession.