The Fed's tightrope act

It's a long way down with no net. It may just take one more gust of wind and it's down down down.

Harry

The Fed's tightrope act

The banking industry is in a quagmire but the economy really isn't in that dire shape. And inflation is still an issue. What's Ben Bernanke and company to do?

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By Paul R. La Monica, CNNMoney.com editor at large

December 13 2007: 1:02 PM EST

NEW YORK (CNNMoney.com) -- The financial services industry is reeling due to exposure to bad subprime mortgage loans. But some market observers suggest that the rest of the economy is still in relatively decent shape, which could mean that the Federal Reserve may not cut interest rates that much further in 2008.

On Thursday, the government reported that the Producer Price Index, which measures wholesale prices, rose 3.2 percent, the biggest jump in 34 years. To be sure, much of this increase was due to soaring oil prices.

But the so-called core PPI number, which excludes volatile energy and food prices, rose 0.4 percent, above Wall Street's expectations of just a 0.2 percent increase. This could be a sign that inflation is still a concern.

What's more, despite all the doom and gloom about the housing market, the Commerce Department reported Thursday that retail sales surged 1.2 percent in November. And even if you exclude sales at gas stations, which were obviously juiced by rising prices at the pump, sales were still up a healthy 0.6 percent.

Largest jump in 34 years for wholesale prices

Add this up and the Fed's two big announcements this week suddenly seem to make a lot more sense.

"It's clear that the economy's moderation in recent months has been relatively gentle. There has been no outright collapse," said David Resler, chief economist with Nomura Securities International. "The economy may be on the soft side, but that doesn't mean we're going into a recession."

The Federal Reserve cut two key interest rates by only a quarter of a percentage point Tuesday, a move that caused Wall Street to panic. The Dow plunged nearly 300 points.

Many investors were hoping for a half-point cut, or at the very least, a half-point cut to the discount rate, which is what it costs banks to borrow directly from the Fed. But Wednesday, Ben Bernanke & Co. saved face somewhat by announcing a plan to inject billions of dollars into the banking system.

In conjunction with several other central banks in Canada and Europe, the Fed said it would conduct four auctions in the next month that will allow banks to bid for loans. Sources said it will probably cost banks less than the 4.75 percent discount rate to borrow money this way.

The combination of a mild rate cut and the new auction system seems to indicate that the Fed is looking for a creative way to solve the credit crunch on Wall Street rather than by simply slashing interest rates.

Source here.