Is the Fed being short-sighted in rushing to prop up a wobbly stock market?. Tom Sowanick is CIO of Clearbrook Research, part of Clearbrook Financial, a Princeton, N.J.-based wealth-management service provider.

William Poole, president of the St. Louis Federal Reserve Bank, gave a curious speech last Friday. In "Market Bailouts and the 'Fed Put'" (delivered to a gathering at the cato.org Cato Institute) he says that lowering interest rates in response to market turbulence constitutes neither a "moral hazard" nor a "Fed put" for the market. But, he adds, even if recent Fed action does amount to a "put" -- an option contract that lets the contract buyer sell an item for a certain price during a certain period -- it doesn't actually achieve moral-hazard status because it's a byproduct of the U.S. central bank's attempt to foster "macroeconomic stabilization," which doesn't necessarily "guarantee that individual firms and households will be protected from failure."

It seems to me that Poole protests too much -- perhaps out of a sense of guilt.

A moral hazard comes into play when a party that is insulated from risk behaves differently as a result of this insulation. For example, someone with insurance against auto theft might be less diligent about locking his car because the negative consequences of this inaction are in part borne by the insurance company.

One sided

In recent weeks Federal Reserve officials have spotlighted the importance of financial-market performance to the broad economy. Up till now, unfortunately, this view has been asymmetrical in that it has only considered the downside performance of financial assets and not the upside.

I think the Fed's ultra-low interest rate policy of 2002-2003 is partially responsible for the current credit squeeze. Another round of aggressive rate cuts is likely to create more problems down the road. Consider, for example, investors who are fleeing risky assets in favor of money markets. They will earn less and less on their investments as the Fed lowers rates. Now think what happens to the price of bond funds when interest rates eventually return to more rational levels. The moral hazard is that by focusing only on the liability side of the consumer, the Fed is at risk of harming a much larger segment of the population by reducing investment income.

Having low interest rates relative to our trading partners is also taking its toll on the U.S. dollar. The dollar is near-record lows and it is likely to continue its descent if the Fed lowers rates by 50 basis points in a few weeks. Foreign lenders to the U.S. would frown upon this outcome.

Another problematic outcome of the Fed rushing to tackle the equity markets' weak November performance is that it challenges the central bank to talk about strong markets as well. If the Fed only addresses weak market performance, then indeed it will have established a biased view while legitimizing the "Fed put" scenario -- something that's redolent with moral hazard.

It would be interesting if the Fed were to start offering investment advice. With interest rates so low, would it recommend buying bonds, Treasury bills or stocks? Would the Fed recommend that U.S. investors look for assets overseas, assuming that more rate cuts are forthcoming?

Of course the Fed will never tell us, so we're back in moral-hazard territory. Should we buy stocks because dividend yields are greater than bond yields, or should we purchase bonds and hope for more rate cuts? I say buy stocks.

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