17 September 2008
Federal Reserve Holds Funds Rate Steady Amid Market Turmoil
U.S. central bank also provides emergency loan to insurance company AIG
Washington — The Federal Reserve is keeping its critical benchmark interest rate steady at 2 percent. The move comes amid global financial market turbulence stemming from the announcement that the major investment banking firm Lehman Brothers was seeking bankruptcy protection.
The Fed said it was acting "as needed" based on current economic and financial conditions.
The Federal Open Market Committee, the central bank's policymaking committee, in making its announcement September 16 said, "Strains in financial markets have increased significantly and labor markets have weakened further." The committee voted unanimously to hold the federal funds rate steady.
Since September 2007, the Fed has cut the federal funds rate, the rate banks are charged for overnight loans, from 5.25 percent to 2 percent to loosen credit availability.
The Fed said that in making its decision it was equally concerned about the risks to economic growth and the risks from a rise in inflation if the funds rate were reduced further. Many in the financial markets had been anticipating another rate reduction September 16.
"Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities," the Fed's statement said. "The committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain."
Adding further turmoil to global markets was the nearly simultaneous announcement over the weekend that the investment firm Merrill Lynch agreed to be acquired by Bank of America. The U.S. and most global markets underwent significant swings in trading September 15 following the news about Lehman Brothers and Merrill Lynch, but the Asian financial markets were closed for a holiday and began reacting to the developments only when they resumed trading September 16.
And in a further effort to rein in the current financial crisis that has destabilized the global economy and scrambled world stock markets, the Federal Reserve announced late September 16 that it will provide a two-year $85 billion emergency loan to American International Group (AIG), the largest insurance company in the United States and one of the largest in the world. Meetings had taken place most of the day at the New York Federal Reserve Bank with Fed officials and representatives from the financial giants JP Morgan Chase, Goldman Sachs, and Morgan Stanley. AIG had been struggling to find at least $75 billion in fresh financing to maintain current operations.
Under the terms of the arrangement, the U.S. government will receive a 79.9 percent stake in AIG in warrants called equity participation notes. The two-year loan will carry an interest rate of Libor plus 8.5 percentage points. Libor is the London interbank offered interest rate, which is a common short-term lending rate. And the two-year emergency loan is secured by AIG's insurance businesses, giving the U.S. government protection if the stock markets continue to decline.
"In current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance," the Fed said in a statement. AIG was facing severe financial distress following billions of losses over three quarters from securities that were linked to home mortgages, which plunged in value as the U.S. housing crisis worsened earlier this year.
White House spokesman Tony Fratto said "these steps are taken in the interest of promoting stability in financial markets and limiting damage to the broader economy," according to the Associated Press.
President Bush said September 15 that he understood the public's concerns about the nation's financial markets.
"As policymakers, we're focused on the health of the financial system as a whole. In the short run, adjustments in the financial markets can be painful both for the people concerned about their investments and for the employees of the affected firms," Bush said at the White House.
"In the long term, I'm confident that our capital markets are flexible and resilient, and can deal with these adjustments."
U.S. Treasury Secretary Henry Paulson told reporters at a White House briefing September 15 that "we're working through a difficult period in our financial markets right now." He praised the Federal Reserve and the U.S. Securities and Exchange Commission for working to minimize disruptions to global financial markets and the broader U.S. economy.
"The housing correction is at the root of the challenges facing our markets and our financial institutions," he said. "I believe that we've taken very important steps with respect to Fannie Mae and Freddie Mac, and they're amongst the most important actions we can take to work through this turmoil."
The Treasury seized control of the nation's two largest mortgage finance companies September 7. The companies were placed in a government conservatorship that removed the current management of the companies. Paulson said the measure was essential to stabilize financial markets.
Fannie Mae and Freddie Mac hold about half of the $12 trillion mortgage debt in the United States.
Paulson said he was working with U.S. and international regulators and congressional policymakers to take additional steps to maintain the stability and orderliness of the financial markets.
"We have an archaic financial regulatory structure that came in place a long time ago, after the [Great] Depression. It really needs to be rebuilt," he said.
Congress has begun studying new regulations for investment banks and a new federal regulatory role in the mortgage market in the wake of the financial crisis that began with mortgage lenders.
David McCormick, the Treasury under secretary for international affairs, said September 16 that "to mitigate disruption surrounding the bankruptcy of Lehman Brothers, the SEC, the Federal Reserve and major global financial institutions each took a series of extraordinary steps. The Fed broadened eligible collateral of certain lending facilities; SEC took steps to protect customer accounts at Lehman Brothers; [and] major market participants have stepped up to their responsibility to support stable and orderly markets."
McCormick also said Bush administration officials have had “ongoing communication with key counterparts in industrial economies and emerging economies. Key policymakers [around the world] have understood, throughout the process, why actions have been taken. They have given a favorable response.”
The Federal Reserve said it will continue to monitor economic and financial developments and will act "as needed to promote sustainable economic growth and price stability."
The Fed said over time the substantial easing of monetary policy through its interest rate cuts, combined with measures to improve market liquidity through central bank lending, should help to promote moderate economic growth and stability.
