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Thursday, 27 September, 2001, 16:37 GMT 17:37 UK
Analysis: Greenspan's generous policy
Federal Reserve building
The Fed is going easy on the banks
By the BBC's Rodney Smith

Many Wall Street bankers are smiling quietly at what they believe has been a very slick piece of cash management by the Federal Reserve.

In the 12 days or so after the attack on the World Trade Centre, the Fed channelled a massive flow of money into the banking system in such a way that, to quote one observer, "banks were drowning in cash".

It was a tried and tested technique of Federal Reserve chairman Alan Greenspan.

Unlike in past financial crises - the most famous was the Wall Street crash of 1929, when the Fed tightened monetary policy, increasing interest rates - Mr Greenspan believes that providing lots of cash is the surest way to beat financial paralysis.

Crisis management

He has done it before - most recently during the Russian banking crisis of 1998.

Mr Greenspan's policies have won him many critics; fundamentalist or monetarist economists believe that when the Fed floods the market with money it is putting off the day of reckoning.

Right or wrong, it is hard not to argue that there has been a merit - albeit short term so far - in the Fed's actions of the past two weeks.

New York bankers report that in the four days after Wall Street re-opened, the Fed was targeting a low overnight lending rate of just 1% to 2%, thus pouring an estimated $100bn into the banking system.

Alan Greenspan, Chairman US Federal Reserve
Mr Greenspan: believes lots of cash beats financial paralysis

It had already added an estimated $30bn - $50bn in the week of the attack, before the stock markets reopened.

This all managed through the banks-only repurchase (repo) market, where the Fed borrows securities, mainly bonds, from the banks and the securities houses - in this case, paying them below market rate.

While Wall Street was closed, there was no competition for securities anyway.

The result was that the actual rate the banks were paying, fell nearly to Japanese levels - then 0.25%, now reduced even further to 0.1%. Christopher Lowe at First Tennessee Securities says that this effectively injected huge amounts of money into the US financial system.

Destroyed financial records

In other words: The Fed was giving money away.

With the Fed funds rate at 3%, banks were making between 1% and 2% on overnight money.

But they had to pay for it. The Fed had made it clear to the banks, and the securities houses, that they were to be equally lenient with clients, big and especially small.

With many records destroyed or missing in the Twin Towers and damaged surrounding buildings, the Fed warned banks to extend leniency for small companies, even individuals, that had to meet short term obligations.

And at very low rates of interest, any penalties would have been relatively small.

'Go easy'

Conditions have improved this week, but the word from the Fed to the banks, apparently, is still to go easy.

There will be grumbling by the losers - the investors with short term obligations, the municipalities, the school districts and the like with regular payrolls, who were forced to invest at very low rates.

But the slickest part of the operation may eventually turn out to have been the manner of the Fed's execution.

When conditions improve the Fed has the flexibility to tighten the huge credit window it has created without having to announce it is doing so - simply by changing the overnight rate and leaving the much watched key rate unchanged.

Mr Greenspan would then be able to avoid any adverse comment at a difficult time.

See also:

11 Sep 01 | Business
Attacks 'blow to US revival'
12 Sep 01 | Business
Dollar's solid image threatened
13 Sep 01 | Business
Will US consumer confidence fade?
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