The present market crisis has posed the first real test for Mr. Bernanke. The deepening crisis in the housing market is now threatening to spill over to other parts of the economy. The result is that hedge funds are in trouble. As they panic and bail out of risky securities, they are putting pressure on stock prices worldwide. It is now threatening to turn into a downward spiral which, theoretically could push the U.S and the world into economic recession.
The first fallout of the present crisis is that suddenly liquidity has dried up. Hedge funds who typically invest in riskier assets are the first ones to feel the heat. Central Banks, the world over have responded by "injecting" money into the system. How do they do this? They have simply gone out and bought bonds from various banks held by them as reserves. The resultant increase in liquidity, $62 billion on Thursday and Friday in the U.S. alone, has a two fold effect. It prevents a spike in the lending rates and it also reassures people that they need not liquidate their assets in a hurry, thereby minimizing losses.
Admidst this turmoil, calls for cutting the interest rates by the Fed are mounting. Critics are quick to point out that such action would simply postpone the crisis as, theoretically speaking, lower interest rates would revive the housing market and would prompt the risk takers to again start buying risky assets. Then again, should government policy be aimed at helping out billionaire hedge fund managers and their millionaire investors?
The proper course of option presently would be to wait and watch. If the number of people involved is small, the crisis would perhaps blow over, once there is ample liquidity in the system. Otherwise the Fed may be left with no other option but to cut interest rates.