No Rate Cut by a Confident Fed

The Federal Reserve.

The Fed knows it's playing a dangerous game. If markets start to believe that the government backstop has been removed, expect financial sector problems to emerge at a more scorching pace among banks most exposed to the weakest parts of the market and at companies in desperate need of fresh capital. Consolidation that began with the $50 billion emergency buyout of Merrill Lynch by Bank of America may just be getting started.

The decision to stick with current policy is both largely frightening, and the best the Fed can do. As Harvard's Kenneth Rogoff, writing in the Washington Post, puts it:

Letting a big investment bank go, as the Fed and Treasury did this weekend, was a calculated risk in a difficult situation. And the risks are very real. With the immense interconnectivity of the financial system, there really is no telling where the unprecedented failure of a big investment bank might lead. On the other hand, ponying up tens of billions in tax money, as the Federal Reserve did in March when another investment bank, Bear Stearns, collapsed, is no answer, either. With the housing market still weakening, with U.S. exports likely to suffer as the global economy falters and with unemployment rising, it is clear that simply bailing out Lehman Brothers would not stop the rot in the financial system.