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Friday, August 31, 2007

The Short View Fed Rates and Commercial Paper By John Authers

The Short View Fed Rates and Commercial Paper By John Authers
Copyright The Financial Times Limited 2007
Published: August 31 2007 03:00 | Last updated: August 31 2007 03:00

The market expects Ben Bernanke to do his duty. The message to the US Federal Reserve could not be clearer. Traders expect a cut in the Fed Funds rate.

But the Fed chairman and his colleagues face a deep dilemma as they meet in Jackson Hole today. Those very expectations provide a strong reason for them to resist the calls.

The expectations can be seen in the renewed flight to the safety of the shortest dated Treasury securities, which seldom vary far from the Fed's target Fed Funds rate. Yields on 3-month T-bills are at 3.6 per cent. The Fed Funds rate is 5.25 per cent. Futures imply that, in two months, Fed Funds will be down to 4.75 per cent.

There are good reasons for a cut. One of the three specific reasons for setting up the Fed, listed in the Federal Reserve Act of 1913, was to "afford means of rediscounting commercial paper" - extending short-term loans.

Banks have acute problems with commercial paper, the short- term debt that underpins many transactions. The amount they have raised this way has fallen $250bn (£124bn) in three weeks.

Since the New Deal, the Fed has also had to pursue "full employment". Early indicators suggest that unemployment is rising. Initial US jobless claims have risen five weeks in a row. That also could justify a cut.

The problem for the Fed is that expectations seem to reflect a cocksure certainty that a "Bernanke Put" is in force. A "put" option allows you to sell for a fixed price: the phrase refers to the belief that the Fed will cut to bail out the stock market if share prices fall.

The surge in Fed Funds futures immediately followed the drop in US financials' share prices.

This is no coincidence. The market assumes that distress for financial institutions guarantees rate cuts in its wake. This implies no downside for taking stupid risks and is toxic for the Fed's credibility.

The Fed governors may need that fresh mountain air.


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