Fed Faux Pas

Last weekend the French bank Societe General discovered they had a problem. One of their employees had been making unauthorized trades, and had lost a couple of billion dollars in the previous two weeks. SG sold a lot of stock on Monday getting out of the losing investments and raising cash to cover the losses. Unfortunately for them it was a bad day in the market because Asian markets already had recorded big losses due to concern about a recession in the US. That's the way it is in a nervous economic environment. Traders in London get skittish about a down day on the Mumbai stock exchange. Big losses on the Mumbai? Please spare me big losses on the Mumbai. By the time S G completed their selling on Monday the two billion loss had turned into a seven billion loss Their selling, on top of the bad news from the Asian markets had driven the markets down 5% in Europe.

So Tuesday morning, everyone was all up in the air about where the US markets would open, It appeared they would open 5% lower, and continue down from there. Fed Chairman Ben Bernanke's phone must have been ringing off the hook with calls from Goldman Sachs, Citigroup and all the other "investment bankers", saying he had to do something big, so he did. He cut rates by 3/4%, the biggest cut in 25 years. The market rebounded, especially stocks in financial companies, which I happened to be short at the time. So he cost me a few hundred dollars, but that's OK, and that's not really the point.

The point is the Fed's mission is to control the money supply to avoid inflation, and cutting rates at a record pace is just the opposite of controlling inflation. Well, Ben would explain, the Fed also needs to insure orderly markets. Thing is, orderly markets sometime go down, and I dont guess Ben would have seen the need for intervention if the market looked like it was going to open up 5%.

The episode is embarassing for the Fed and may be recalled in the future as one of the institution's darkest days. (and there's a lot of competition for that honor).
The fed used the biggest arrow in it's quiver to deal with the consequences of some French guy losing a couple billion in unauthorized trading.

Two other observations, one amusing, one not so amusing. The European central bank knew what was going on at Societe General amd didn't respond with precipitous action. They take their job of controlling inflation seriously. They also didn't bother to give Ben a jingle and clue him in. Seems like that would have been the neighborly thing to do for a respected fellow central banker - which I guess he isn't.

The not so amusing part was the panic in the pits which prompted Ben's over-reacton.
Ask yourself, friends, don't brokers make money buying and selling? As long as they're getting paid why should they care if the market's going up or down? Well, it's because for trades to occur to earn commissions on, there has to be money in the market to trade. And market declines mean somebody is losing money, and they're afraid, very afraid, that some of their biggest customers, the hedge funds, are running out of money. Rumors circulated Friday of a big hedge fund in trouble. We'll wait till Monday to see. But a word of caution to Ben - you can only cut rates by 3/4% so often before you're paying people to borrow. Oh wait, when you factor in the real inflation rate, that's what we've been doing for several years.
Well anyway, you don't want to look any sillier than you already do.