The biggest danger is excessive expectations. Liquidity provision, however artful, is not a magic bullet for the credit crunch. It alleviates panic and buys time, but does not eliminate the underlying losses, get rid of the uncertainty about who holds them, or prevent the inevitable credit tightening that will follow.
And the bad news is far from finished. As foreclosures and falls in house prices accelerate, estimates of likely losses on mortgage-backed securities, now around $400 billion, are still rising. The credit contraction these losses will spawn has hardly started. Yet the economy is already in recession. That is not official, but the latest jobs figures, which showed private-sector employment falling in each of the past three months, leave little doubt that the economy is contracting. More mortgage losses will result as joblessness spawns foreclosures, along with higher defaults on everything from credit cards to corporate loans.
There are some bright spots. Banks are limiting the scale of the squeeze by raising new capital, over $100 billion so far””though they could raise more. The downturn is being cushioned by still-strong global growth (see article). George Bush’s fiscal stimulus package will soon add a short boost. But, all told, recession suggests the credit problems will get worse before they get better. The Fed’s sandbag strategy will help ward off disaster, but it won’t shore up a sagging economy.