Of Fed, RBI and inflation

A week ago, the US Federal Reserve had to invoke a Depression-era law so that it could lend to Bear Stearns, the fifth largest brokerage in the US.

The Fed then orchestrated the takeover of Bear Stearns by J P Morgan Chase & Co over the weekend. The deal staved off a possible Bear bankruptcy, which the central bank feared might have traumatised financial systems worldwide.

The last time it used this law was in 1971, when the commercial paper market seized up after Penn Central, the largest rail-road company at that time, collapsed. The fact that the Fed has acted in a similar manner now tells us how seriously it believes the financial system is at risk.

While “Helicopter” Bernanke is living up to his image of dropping dollars from a helicopter, he is being innovative. No one can accuse him of sitting on his haunches and doing nothing to prevent the economy from going into recession.

The Fed’s action is quite in contrast to its role in the 1930 collapse of the Bank of the United States. The failure was then the largest in US history and the Fed’s inability to arrange a rescue by Wall Street banks caused a devastating loss of confidence in the entire US banking system. That fuelled a panic that historians regard as a key cause of the Depression.

With interests rate now down to 2.25 per cent, the Fed is probably left with just 0.75 per cent to cut unless it wants to send the economy back to 1 per cent, a rate that is supposed to have given birth to the current crisis. I don’t see the Fed going beyond 1.5 per cent and may depend on other unconventional methods like outrightly buying the troubled securities rather than lending to the banks.

The opening up of the Fed window to anyone who needs money has made the Fed the lender of the first resort, a role it should not be playing but which Bernanke will increasingly play.

These steps show the resolve with which the Fed is ready to move. The turnaround seen in our markets on Wednesday largely stemmed from the better than expected quarterly results posted by Goldman Sachs and Lehman Brothers in the US.

After the sell-off seen in the stocks once in the Bear Stearns portfolio in India, the market men had been pouring over the portfolio of other US I-Banks. Those sheets have not been consigned to the trash bin as yet. They have carefully been saved on the desktop for ready reference later, should one of those go belly up.

Another area of discomfort is the pending conversion of FCCBs. Corporate India had very eagerly placed FCCBs with FIIs and other QIBs. These FCCBs are supposed to be converted into equity shares at a pre-decided formula or price.

As the stock prices have now fallen sharply from the levels seen in January, investors may not be interested in conversion at all or may want to rework the price lower. In both cases, the companies will suffer.

If the price is lowered, the addition to equity will be higher than envisaged earlier and if the conversion does not happen, interest rates will mount. And if the borrowing happens to be yen or any other currency that has appreciated, god forbid.

Inflation is another thorn in the flesh. For the week ended March 8, inflation has been reported at 5.92 per cent. This is way beyond the comfort level of the RBI. So any hope the markets may have had of a rate cut following the slashing of rates in the US will be nipped in the bud. There might be a case, on the contrary, for tightening the nuts.

The solace that the banking and real estate sectors were seeking is not on the horizon. These two sectors have also seen the largest losses from their January highs of 40.8 per cent and 48.8 per cent, respectively.

The BSE consumer durable is the only other sector that has fallen more — 49.3 per cent. The weakness in commodities may help reduce global inflation but not ours, which is in a time warp of its own.