The key criterion

The Fed has another reason to want short-term rates lower than long-term rates. This is classically how banks make money — on the spread. Also, banks still need to recapitalize, despite having written down so much bad paper and bringing in new investors (a total of $69 billion so far from sovereign wealth funds and a few rich individuals). Banks need to recapitalize to polish off whatever remains of toxic investment, but also to stay ahead of the upcoming expected surge in consumer defaults.

The Fed gave this clue in a subtle way. Its statement read: “While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households.” Any economist worth his salt will zero in on the statement that “credit has tightened.”

In fact, just a few days before the Fed rate cut, Business Week ran a story on the “tapped out consumer.” Banks are setting aside reserves for credit-card and other consumer debt it expects to go south. Five banks alone — Citigroup ($3.3 billion), JP Morgan Chase ($2.3 billion), Wells Fargo ($1.4 billion), American Express ($440 million) and Capital One ($650 million) — are reserving $8.09 billion. Citigroup says it is raising credit card rates to protect itself from late payments. The Business Week article indicates banks will not lower consumer credit rates no matter what the Fed does.

The consumer is the engine of the U.S. economy. With housing prices yet to finish dropping and consumer credit drying up, the Fed is right to worry about deteriorating sentiment and market activity. This situation is no different from any other financial sector crisis, including the Asian financial crisis of 1997 that started in Thailand or the 1989 crisis in Japan that started with a stock market crash and ended in a decade-long depression. This is the inevitable outcome of over-leveraging coupled with lax credit standards — banks always have to recapitalize.

Of course the charge can be thrown at the Fed that by cutting rates and cutting them a lot, it is only inspiring a new bubble characterized by over-leveraging. The previous rate-cut cycle that took the fed funds rate down to 1 percent is blamed (correctly) for causing the housing bubble in the first place. That various agencies including the Fed were lax in their regulatory duties is not incidental, though. The point is the U.S. economy depends on leverage to a greater extent than any other economy in the world. Starting the re-leveraging process is the Fed’s only hope of averting a bank recapitalization caused recession.

This is what the Fed knows that we don’t: The need to recapitalize banks is absolute. The $69 billion in new sovereign wealth fund capital already acquired is not enough. Citigroup, for example, plans a public issue that will carry the same 7.25 percent preferred dividend yield given to one of its new sovereign fund investors. How much new capital do the banks need? What is the right number? You can bet the Fed has an estimate, even if no one else does. It cannot stop cutting rates until the bank recapitalization process is nearing completion. Again, this is unlikely to occur before the end of the second quarter on June 30. Bank losses may be hundreds of billions larger if bond insurance companies (like AMBAC, MBIA, and others) fail to deliver insurance proceeds and/or go bankrupt, requiring a government bailout of their own, as now seems likely, as a result of improperly rated paper.