Fed's Loans to Wall Street May Prevent Raising Rates This Year

By Scott Lanman

July 8 (Bloomberg) -- The Federal Reserve may hold off on its first interest-rate increase since 2006 until policy makers judge that financial markets are stable enough to allow the central bank to withdraw its lending backstop for Wall Street.

Raising rates while at the same time removing securities dealers' access to direct loans from the central bank would be a double hit to markets that officials probably want to avoid, Fed watchers said. The Fed also may have a hard time justifying higher borrowing costs before it has a plan for ending emergency lending to nonbanks.

The timing difficulty, along with continued strains in credit markets, means traders may be mistaken in estimating the odds of a rate boost by year-end at 74 percent.

``We think they'll wait until 2009,'' said Brian Sack, who used to head the Fed's monetary and financial market analysis group before he joined Macroeconomic Advisers LLC as senior economist in Washington. Successfully dealing with an end to the Primary Dealer Credit Facility is ``a hurdle for credit markets to get past before the Fed will likely start tightening,'' he said.

Bernanke, who spurred expectations for a rate increase when he said last month the Fed would ``strongly resist'' a jump in inflation expectations, speaks today on financial stability and regulation. His remarks to a Federal Deposit Insurance Corp. forum are scheduled for 8 a.m. in Arlington, Virginia. Treasury Secretary Henry Paulson also speaks.

Fed Powers

The Fed started the PDCF in March, invoking its powers under ``unusual and exigent circumstances'' to forestall a collapse in confidence after the near-bankruptcy of Bear Stearns Cos.

New York Fed President Timothy Geithner, who spearheaded the central bank's rescue of Bear Stearns, said June 9 that the Fed's emergency measures would be in place as long as markets remained distressed. Persistent credit strains may leave officials unwilling to end the PDCF in September, after they said March 16 it would last for ``at least'' six months.

Credit-default swaps on Lehman Brothers Holdings Inc., Merrill Lynch & Co. and Morgan Stanley debt are trading close to their highest since March. The contracts let investors bet on the risk that a company will default on its bonds.

Another gauge of financial stress watched by the Fed has also remained elevated. The difference between the overnight indexed swap rate, a measure of what traders expect for the Fed's benchmark rate, and three-month interbank loans in dollars was 0.78 percentage point yesterday, about the same as the start of May.

`Severe Stranglehold'

In addition, commercial-bank loans outstanding have dropped to their lowest level since March, Fed statistics show. That will ``put a severe stranglehold on economic growth,'' said former Fed governor Lyle Gramley.

Raising rates in such an environment ``would be a very risky strategy,'' said Gramley, now senior economic adviser at Stanford Group Co. in Washington. ``I don't think they're going to do that, and I think markets have been premature in jumping to that conclusion.''

The Federal Open Market Committee on June 25 kept its target rate for overnight loans between banks at 2 percent, ending a series of seven reductions since September.

Futures prices on the Chicago Board of Trade indicate investors place 47 percent odds the Fed will raise the benchmark rate to at least 2.25 percent at or before the Sept. 16 meeting. That probability is 74 percent for the end of the Dec. 16 FOMC gathering.

One at a Time

``They're going to pick one instrument at a time to tighten policy,'' predicted New York-based Merrill Lynch economist Drew Matus, who used to work at the New York Fed.

While nothing would prevent the Fed from taking such action, increasing the cost of credit while at the same time lending to Wall Street may spur criticism the central bank is misusing its emergency authority.

The Fed is only supposed to lend to nonbanks under emergency circumstances when no other ``adequate'' credit is available. The PDCF and the Fed loans to secure Bear Stearns's takeover by JPMorgan Chase & Co. were the first extension of funds to nonbanks since the 1930s.

Richmond Fed President Jeffrey Lacker and Philadelphia Fed chief Charles Plosser have already criticized the PDCF for raising the danger of future financial crises by increasing incentives for firms to take on more risk.

The PDCF was one of three tools the Fed introduced since December to combat the credit crisis. The central bank has a $200 billion program of lending Treasuries to the primary dealers in U.S. government bonds. The Fed also auctions $75 billion of cash loans to commercial banks every two weeks.

``If those tools work, then monetary policy can go back to addressing what it should be addressing, which is inflation,'' John Ryding, the founding partner of RDQ Economics in New York who used to work as an economist at Bear Stearns and at the Bank of England, said in an interview with Bloomberg Radio. ``The problem is, I think it's clear, that there's still a lot of fragility in the system.''

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net