Fed Keeps Rates Steady: Time to Confront Reality

by: Markham Lee

Citing inflation concerns as being more important than the recent problems in the credit markets, the Fed decided to keep the funds rate steady at 5.25%. The Fed didn’t ignore credit issues entirely, as they did acknowledge that the credit crunch could have a negative impact on future growth. However, for the time being, their focus is on inflation and the Fed Governors voted unanimously to keep the funds rate steady.

I agree with keeping the federal funds rate steady, because it’s not the Fed’s job to make life easier for people who originated bad loans or over-leveraged and/or made bad investments. Perhaps the Fed’s decision can be seen as one of “asking the markets to confront reality” as bad lending standards, loan defaults, over-leveraging and borrowing against over-valued “mark to model” securities are the causes of the credit crunch, not high interest rates.

The rest of the week is going to be interesting as the markets will have to accept that a rescue isn’t coming in the form of a lowered interest rate, and face reality with respect to the true causes of the credit crunch. Expect to see more hedge fund and lender casualties over the next two weeks, as they’re forced to reveal losses in debt securities and liquidity issues mount. I also wouldn’t be surprised to see another brokerage house or major bank report problems similar to Bear Stearns due to investments in debt securities.

For private equity, it’s probably safe to say that the boom times are over for now, multiple deals are in trouble over financing, and without a rate cut, that’s unlikely to change anytime soon. However, I can see some of the remaining deals going through anyway, (like the Cerebus’ buyout of Chrysler) but new deals will face a rather uphill climb due to the credit crunch.

Moving forward, the critical questions are now as follows:

1. Will the markets confront the business practices that got us here and develop new operating standards to prevent a similar situation in the future?
2. Will the financial sector actually learn from this debacle?
3. Will the Fed eventually just lower rates to save the day and re-start the cycle that got us here when Greenspan started lowering rates a few years back?
4. Does Bernanke have the courage to keep rates steady in the face of mounting pressure from the financial sector to lower them?

Only time will tell. For now, it’s unlikely that the credit crunch will unfold precisely in the manner that anyone predicts and it’s going to be interesting to see how this all plays out.

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