Lou Thomas

An End-of-Quarter Dollar Rally in Face of Bailout Drama

It is important to remember that the fed sets a *target* rate for lending between banks, presently at 2 percent, that captures all of the public attention, but this rate must be supported by open market operations that inject liquidity in order to cause the *effective* rate of lending approximately match that target.

Lately, while the target rate has remained at 2 percent, the effective rate has swung wildly as high as 7 percent and as low as about 1.3 percent. So, while public perception may be that the rate is at 2 percent, the effective rate is the result of the Fed's actual policies, as well as market conditions, including the overall reluctance that banks have to lend to one another.

The Fed fund futures mentioned in the article are settled at the effective rate, not the much more visible target rate, and so that is probably one of the main reasons that they do not accurately predict what the Fed is going to announce publicly as its target.

It occurs to me that since the dollar is extremely vulnerable, the Fed may not want to cut the visible rate, but may still be undertaking policies that attempt to lower it below the public target of 2 percent. I say attempt because in the current environment, dominated, as the article notes, by counterparty risk, this may not always be possible. Hence, the wild fluctuations in the effective rate, which usually follows the target fairly closely.

Since a rate cut must be supported by open market operations to inject liquidity sufficient to cause banks to lend to one another at the lower rate, and since the Fed has already swapped a great deal (all?) of its original 900 billion of good stuff for junk collateral, one has to wonder whether the Fed actually has the wherewithal to support a lower effective rate, but so far they are below the target at least some of the time. Didn't the treasury have to do a special bond issue to back $40 billion of the AIG bailout? That may have been the point that the Fed's assets were (at least temporarily) exhausted.

Regarding the LIBOR, while home equity loans were mentioned, the larger problem would seem to be ARMs, which are generally tied to the LIBOR. The ARMs are in the pipeline fully ARMed and waiting to explode in the coming months. If those adjustable rates are adjusted way higher due to LIBOR increases, it will make the calamity just that much worse.

Overall, a reasonable and well-considered article, IMHO.