Merk Investments: FOMC: Towards A Post Wall Street Environment

Given the extraordinary events of the past three days the market has moved quite sharply towards an expectation of a 25 basis point cut. At publication of this note, Fed fund futures imply a 92% probability of such a cut, but the options market suggests an 84.5% probability of the FOMC remaining on hold. Thus, it is far from uncertain that committee will choose to cut rates in light of the failure of Lehman and the forced merger of Merrill Lynch with the Bank of America.

The steps taken over the weekend to expand the collateral eligible to be accepted by the primary dealer credit facility and the addition of $50 billion available to the financial community via the term securities lending facility are sound and necessary steps. However, we think it prudent that the Fed keep its powder dry at this juncture and reserve what firepower it has left to address any future spillover of the current turmoil into the real economy.

In our assessment the Fed took the correct steps in not providing a backstop behind Lehman and in urging Merrill Lynch to seek a private market solution to its own problems. The resources of the Federal Reserve are potent, but not endless. The precedent created by the bailout of Bear Stearns and the seizure of Fannie Mae and Freddie Mac created the impression that any firm of sufficient size that might fail would be rescued. The moral hazards embedded in those actions could not be sustained and the refusal of the Fed to bailout Lehman represents a good first step towards a more rational framework for U.S. financial markets.

While, the market is correctly focused on the direct action that the FOMC may or may not take, we think that the upcoming statement carries a far greater burden. This statement needs to be more than a simple boilerplate communiqué. This communiqué needs to begin to shape the post-Wall Street environment.

The Fed needs to provide guidance on the likely path of monetary policy over the next few months to instill a measure of confidence in the market that is currently absent. We do not think that the crafting of the statement should leave the market obsessing on the meaning of whether the communiqué attaches the modifier significant to the phrase “upside risks to inflation.” More importantly, the statement must reinforce the steps taken over the past 24 hours to shape the context in which markets should expect to operate in the short term and begin to put in place the long-term operational framework in which those firms that survive the current bloodletting will exist.

In particular, the probability that a large insurance company and savings and loan bank may need to be the targets of combined action by the Federal Government necessitate a policy response that not lag events. The likelihood that the U.S. Congress, the Treasury and the Fed will have to take future action to ensure the proper functioning of financial markets has increased. The statement should include language to signal to the market that it stands ready to act in concert with both private markets and public actors to return stability to the markets.

Moreover, it is not sufficient that Mr. Bernanke simply rely on the communiqué to shape and wait until his testimony before the Joint Economic Committee of the U.S. Congress on September 24 to shape market expectations. He should take the bold step and address the public and the markets in the aftermath of the statement. Henry Paulson’s leadership has been necessary but not sufficient. The markets need to hear from the Chairman of the Federal Reserve and he should address it forthrightly.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment product, nor provide investment advice. Merk Investments does not own any of the stocks mentioned; this is not an offer to buy or sell any security mentioned.