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Fed Playbook Calls for Rate Cuts

Written By Brian Hicks

Posted October 29, 2007

To the millions of tourists who have driven down San Francisco’s Lombard Street, it is easily the "crookedest street in the world." Steep and full of hairpin turns, it’s an oddity nearly as recognizable as the city’s Golden Gate Bridge.

But as familiar as that street is to everyone who has either driven it or seen it in a movie, there is another "Lombard Street" that is equally well known among the world’s bankers–particularly its central bankers.

Entitled "Lombard Street, A Description of the Money Market," it was Walter Bagehot’s 1873 plain-spoken attempt to explain the world of international banking, finance, and money. In fact, had it been written today it might have easily been called "Central Banking for Dummies."

Not surprisingly, it’s a book that the current Fed Chairman knows all too well. He kept a copy of it in his Princeton office, and to some it is nothing less than his playbook for the current market crisis.

Fed Rate Cuts in the Cards

I bring it up because given the current crash in the debt markets that I wrote about last week, it now appears with absolute certainty that the Fed Chairman will live up to his nickname-"Helicopter Ben"–after all. Because as the freefall in the dollar and the rise in oil and gold have been telling us since the middle of August, the Bernanke Fed is just getting warmed up.

The Bernanke Put, in other words, is alive and well.

But this time it’s not at all about equities. In fact, it never really has been. That’s why last month’s cuts we’re so large given that the Dow at the time was still close to its all-time highs.

This go round, at least, the cuts are all about one thing: fear in the banking system. That is where Bagehot comes in so handy for the former Princeton professor.

In fact, in a speech just two weeks ago at the Economic Club of New York, Chairman Bernanke even referenced Bagehot’s famous "species of neuralgia" line as he discussed the recent financial turmoil.

Here’s what he said:

"In his classic 1873 treatise, Lombard Street, Walter Bagehot famously articulated the need for central banks to be prepared to lend freely against good collateral (what he called ‘good banking security’) but at a penalty rate. A panic, said Bagehot, is a ‘species of neuralgia’ and as such must not be starved."

That’s a take off Bagehot’s full quote, which reads:

"In times of ‘internal discredit’ (when uncertainty leads private players to pull back and fear replaces greed) the prescription to the central bank is: Lend freely. A panic is a species of neuralgia, and according to the rules of science you must not starve it."

Bagehot wrote, "The holders of the cash reserve"–today’s central banks–"must be ready . . . to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to ‘this man and that man,’ whenever the security is good."

Of course, over time, Bagehot’s 1873 advice has become the standard practice of nearly all central bankers, including our own.

Bagehot on Line One, Mr. Chairman

And consequently, as Bernanke told his audience two weeks ago, "In highly stressed financial conditions, when the market-wide demand for liquidity rises sharply, one of two things must happen: Either the central bank provides the liquidity demanded by lending against good collateral, or forced sales of illiquid assets will drive the prices of those assets well below their longer-term fundamental values, raising the risk of widespread insolvency and intensifying the crisis. If the crisis becomes sufficiently severe, history suggests that damage to the broader economy is likely to follow." (Emphasis mine.) 

That being said, don’t be even remotely surprised on Wednesday if the Fed cuts rates by another 50 basis points, no matter what that may mean for the dollar. The greenback is on its own.

That’s because, when St Louis Fed Chief William Poole said in August that only a "calamity" would justify an interest rate cut now, he may have been on to something, even though he didn’t realize it at the time.

Of course what he didn’t know then was just exactly how big of a problem the debt markets were in at the time.

A scant ten weeks later, however, it is a totally different story-one that borders on the very calamity that Poole was talking about.

That’s why the big banks will continue to be fed with all of the rate cuts that they need and then some–weak dollar or not.

That– in my mind– makes Wall Street the "crookedest street in the world" after all.

Wishing you happiness, health and wealth,


Steve Christ, Editor