NCPA - National Center for Policy Analysis


August 23, 2007

The Federal Reserve's recent reluctance to intervene in financial markets began as fear of inflation, but soon became fear of moral hazard.  In other words, the Fed didn't want to mitigate the consequences of bad behavior which would only encourage such behavior in the future, says Bob McTeer, a distinguished fellow at the National Center for Policy Analysis and former president of the Federal Reserve Bank of Dallas.

Nevertheless, despite some "stealth" policy easing, the market clamored for something more formal.  They got it when the Fed, in an unusual move, cut the discount rate by 50 basis points and liberalized collateral requirements, says McTeer:

  • The markets interpreted this action, and the accompanying statement, as a shift to an easing bias and expect a formal easing at the next committee meeting, if not before.
  • In a continued flight to quality, markets have driven short-term Treasuries well below the 5.25 target for Fed funds.
  • The committee reluctantly fed the alligator and will now have to feed it again, sinking deeper into the moral-hazard swamp.

The new chairman wanted to avoid a "Bernanke put," a perceived floor under the markets.  He didn't want to bail out risky business or, in some cases, funny business.  He rightly wanted to let market discipline work.

On the other hand, babies were being thrown out with the bath water, says McTeer.  The markets were punishing the innocent along with the guilty and leaving them for God to sort out.  Bernanke did the right thing to resist, and he eventually did the right thing by relenting. Better to go easy on some of the guilty than to punish many of the innocent.

Source: Bob McTeer, "Moral Hazard at the Fed," Dallas Morning News, August 23, 2007.


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