Why the Fed can’t put out the fire

Even many of those who believe Fed must make another big rate cut Tuesday concede it can’t do much to calm troubled markets.

By Chris Isidore, CNNMoney.com senior writer
Last Updated: March 18, 2008: 9:32 AM EDT

NEW YORK (CNNMoney.com) — With Wall Street hit by a crisis of confidence, many are hoping the nation’s central bank can save the day.

The Federal Reserve’s main weapon: Cutting interest rates, and most economists expect a big slash of three-quarters of a percentage point on Tuesday.

But even those economists in favor of such a move concede it will do little to calm investor fears.

“It doesn’t address the fundamental problems, which is that financial markets are just scared,” said David Wyss, Standard & Poor’s chief economist. “The Fed is trying, but they don’t have a magic wand to wave and make everyone confident again.”

In the past week, investors have come to expect even more aggressive action from the Fed.

The sudden collapse of investment bank Bear Stearns sparked fears that other Wall Street banks could be at risk. Shares of Lehman Brothers (LEH, Fortune 500) plunged more than 25% in morning trading on Monday. Concerns that another institution could collapse is one reason that the Fed will probably deliver another big rate cut.

But Rich Yamarone, director of economic research at Argus Research and a critic of the Fed’s rate cuts, argues the Fed is feeding current market fears with emergency moves like Sunday night’s decision to make loans directly to Wall Street firms instead of just banks.

“Anytime you act on a Sunday night during ’60 Minutes,’ if you don’t think that will engender fear, I don’t know what does,” said Yamarone.

He added that the Fed should not be trying to prevent failures by Wall Street firms.

“It was almost naive to think this wasn’t going to happen to someone,” he said. “You don’t have a credit crisis of this magnitude and have every player sidestep calamity.”

But Lyle Gramley, a Fed governor from 1980 to 1985 and now a senior economic advisor for the Stanford Washington Research Group, said that such a failure would have far broader implications for the economy and the financial markets and the Fed has to do what it can to avoid that.

“If the Fed had sat aside and let Bear go down the tubes, the cascading effects would have been ghastly,” he said.

Still, Gramley concedes the Fed has only a limited ability to deal with market fears. And he said that makes this economic crisis the most difficult challenge for the central bank since the Great Depression.

“In all past recessions, I was always quite sure that if the Fed stomped hard on the gas pedal, the economy would turn around and start to grow,” he said. “But they’ve now stomped hard on the gas, and credit is not more available, it’s less available.”

Gramley and some other experts believe the solution to the current credit crisis will have to come from Congress, not the Fed, and that the federal government will have to take steps to bail out both Wall Street firms holding mortgage-backed securities as well as homeowners who have mortgages with balances greater than the value of their homes.

“I think the federal government is going to have to recognize taxpayer money will be involved and the sooner we get going on that, the better,” Gramley said. “The longer it takes to do that, the more expensive the bailout will be.”

The Fed took steps to assume some of that credit risk last week when it agreed to accept mortgage backed securities as collateral.

Still, Yamarone and other Fed critics argue that another round of rate cuts will do little but drive the value of the dollar lower versus the euro and the yen, which in turn will further drive up the prices of commodities such as oil and gold.

“Not one company is saying monetary policy is restrictive or that the current interest rate levels are impeding them from investing,” said Yamarone. “A (full percentage point) cut would send the dollar into a potential collapse. We’re in a free fall now, wait till you see what a collapse looks like.”

But many others think the Fed has no choice but to keep slashing rates.

“It helps, even if it doesn’t solve the problem,” said Wyss. “You need to keep the cost of borrowing down. It’s not the optimal solution, but it’s better than nothing.”

And no matter what the Fed does, market fears probably won’t go away any time soon. After all, some investors will probably take more Fed cuts as a sign that the central bank sees more trouble ahead.

“The market is going to stay worried, regardless of what the Fed does. It’s heads you lose, tails you lose,” Wyss said.