After a prolonged period of global economic optimism, the Russian default in mid-August suddenly changed the financial landscape. Quality spreads in the securities markets widened dramatically, and new issues of bonds and equities all but dried up. In response, the Federal Open Market Committee (FOMC) cut the federal funds rate target by 25 basis points three separate times over the past three months. The FOMC focused on the likely effects of the credit market disturbance on the economy and not on the state of the financial markets per se.
As for those financial markets, the key issue now is whether their problems are driven by fundamentals, such as corporate earnings prospects, or by irrational fears. If the latter, investors will straighten things out in time as they re-enter the markets to take advantage of bargains. If fundamentals are the problem, then the policy issues for the Fed will be more difficult.
We are fortunate that the banking system is relatively uninvolved in this financial disturbance. Here is a real, live example of the importance of strong bank capital. Some banks have indeed taken hits from loans that have gone bad during this upset, but bank capital has been fully able to absorb the shock. The best information we have is that bank lending policies, especially by small- and medium-sized banks, have changed little since August.
The stability of the banking system in 1998, in contrast to the somewhat shaky situation in the early 1990s, is a great source of stability for the general economy. The banking system is truly a part of the solution rather than a part of today's problem, and that makes the Fed's job much easier.
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Fed in Print: An index of the economic research conducted by the Fed.