Fed chief caves in to Wall Street

Given the problems in the debt market, the prices of stocks are too high and the risk premium on bonds still too low. If the debt market is on the edge of melting down, if Citigroup (C, news, msgs) is tottering, if the economy is about to slip into recession, nobody seems terribly worried, judging from stock prices here and overseas.

Counting on a safety net

They aren't worried, of course, because they believe that Bernanke has extended the Greenspan promise to bail out the market with cash whenever things get dicey -- which is exactly what the Fed did the morning after it cut interest rates Oct. 31. The central bank injected $41 billion into the markets. That was the U.S. central bank's biggest liquidity injection since the height of the debt crisis in August.

But, gol' dang it (fill in your expletive of choice), investors ought to be scared. There's at least one more debt-market shoe to drop when the current wave of credit-rating downgrades turns into selling, which will force institutions with portfolios stuffed with questionable paper to mark their assets to market prices.

• Talk back: What's your view on Ben Bernanke and the Fed's latest move?

Moody's (MCO, news, msgs), Fitch Ratings and Standard & Poor's all downgraded billions of dollars in mortgage-backed assets in October. Credit downgrades last month from the three rating companies hit $100 billion of asset-backed paper. More shocking than the total, however, was the distribution: Many of these downgrades hit AAA-rated mortgage securities. These securities were supposed to be the safest part of the mortgage-backed debt market. Turns out they're not.

And these downgrades aren't taking AAA-rated paper down just a grade or two to AA or A. Some of this mortgage-backed debt is going straight from AAA to a junk rating. Downgrades like these will force some investors to sell. Many pension funds, for example, are governed by investment rules that prohibit ownership of risky grades of debt and require the sale of assets that fall from the top of the ratings heap. This selling will generate market transactions, which mean market prices, which mean many investors who now have extreme latitude to calculate the prices of portfolio holdings using internal mathematical models will be required to use market prices.

More write-offs, write-downs

So you can expect another round of write-downs and write-offs from banks and investment banks when they report their fourth-quarter earnings in January. (Many will have paid out their annual bonuses by then. Wonder what prices they'll use in calculating those.)

Nothing the Federal Reserve can do to cut or raise rates will have any effect on that marking to market and those write-downs. The debt market's problem right now is the uncertainty of prices. All the Fed can do by providing massive injections of liquidity is make sure there's someone out there able to buy these assets at 70 cents to the dollar.

According to the prices in the Fed funds futures market, it’s likely that the Fed will stand pat at its Dec. 11 meeting. (The market put the odds of "no change" at slightly better than 50% on Nov. 14.) But as we get close to that date you can bet more investors will be hoping for more rate cuts. And you can expect Wall Street to sound the drumbeat of bad news loudly in the run-up to the Federal Reserve's Jan. 29-30 meeting. With the red ink from write-downs and write-offs fresh on the winter's snow, pressure on the Federal Reserve will mount again. Wall Street expectations of a rate cut will climb with every bit of bad news as we get close to those dates.

Sense of entitlement

And why not? The Federal Reserve has conditioned Wall Street to expect a rate cut whenever there's the slightest whiff of crisis.

I thought that it had become part of the economic consensus that in running economic or monetary policy, the key to winning the battle was preventing expectations that inflation would creep upward or interest rates slump downward over time from taking root. Once individuals expect inflation, they behave in ways -- by raising prices, for example, to compensate for future inflation -- that guarantee those expectations will be met.

The longer that Bernanke lets the financial markets believe that the Federal Reserve will bail them out, the harder it will be -- and the more painful to the economy -- to break that expectation. So far Bernanke does not seem to be at all interested in changing those expectations. Maybe he hopes that he can guide the economy from one bubble to another -- as his predecessor did -- without ever having to face the music.

Feeding the inflation monster

The danger, of course, is that each interest-rate cut he supplies to meet Wall Street expectations will, at some time in the future, feed into inflation -- unless the Federal Reserve moves decisively to take back those cuts. Wall Street won't be happy when that happens. But the Federal Reserve's mission isn't to make Wall Street happy.

I just wish Bernanke would remember that and stop being such a wuss. It's time to stand up to the bullies -- whatever their expectations -- and remind everyone that just because you're a big investment house, you still have to take your lumps when you make a stupid investment.

But my best guess is that the Fed won't discover its backbone before the 2008 elections are behind us.

That's what Greenspan and Bernanke have taught me to expect.

Continued: Developments on a past column

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