The Fed buys some time to rebuild confidence

Confidence went out the window on Wall Street this week, and that's why the Federal Reserve had to cut one of its key interest rates Friday.

However else the decision was dressed up -- Fed supporters say policymakers intervened to protect the economy, while critics say the central bank is simply bailing out major financial companies -- this ultimately was about confidence.

Without it, we don't have a financial system. And if the system goes, it almost certainly would take the modern global economy with it.

So the stakes are astoundingly high. And let's note right off, there is no guarantee that the Fed's sudden policy shift will have the desired effect, which is to keep credit flowing.

Indeed, for their own health, many big investors and lenders should stay focused on pulling back from the orgy of borrowing that got the financial system into its current mess. That is why stock and credit markets are likely to remain cautious, despite the 233-point surge in the Dow Jones industrial average Friday.

Still, "at the very least this buys some time," said Doug Peta, market strategist at money manager J&W Seligman & Co. in New York.

In a move announced before markets opened, the cost for commercial banks to borrow directly from the Fed was dropped to 5.75% from 6.25%. And the central bank encouraged institutions to use its borrowing window.

The Fed's action was less significant than a cut in its so-called federal funds rate, which has been at 5.25% since June 2006. Had the Fed lowered that rate banks most likely would have pared the prime lending rate, now 8.25%, by the same amount.

Nonetheless, policymakers soothed battered markets by feeling their pain: "Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward," the Fed said.

As most everyone knows by now, what began early this year as a problem of surging mortgage defaults -- a byproduct of the wretchedly excessive housing boom -- has since spread far and wide. Stunned by mounting losses on mortgage-backed bonds, many lenders and investors have done a complete 180-degree turn, and have looked for excuses to cut off credit, or make it much more expensive, for all sorts of borrowers besides the lowest rung of mortgage applicants.

The stock market has suffered collateral damage, but equities aren't the issue here. At their lows Thursday before buyers flooded in, most major U.S. stock indexes were down not much more than 10% from their recent peaks. To put it in historical context, that's nothing more than a garden-variety "correction" in a bull market.

The real crisis of confidence has been in the bond markets and, increasingly, in the banking system. When mortgage loans of even the highest-quality borrowers can't find buyers on Wall Street; when worried depositors line up at the banking offices of home loan giant Countrywide Financial Corp. to pull their money out; when shareholders of money market mutual funds start calling their fund companies to ask about the safety of the short-term corporate IOUs the funds own -- that's a confidence problem the Fed can't ignore.

Policymakers had some cover Friday, whether they knew it was coming or not: The monthly Reuters/University of Michigan consumer confidence survey showed a drop in the main confidence index to a one-year low of 83.3 this month from 90.4 in July. That suggests the turmoil in financial markets is having an effect on peoples' perceptions of the real economy.

To the Fed's detractors, Friday's rate cut -- and the hint of more to come -- is a de facto bailout of financial companies and investors.

We've seen this movie before: The Fed eased credit after the stock market crash of October 1987; in September 1998, when the huge hedge fund Long-Term Capital Management was collapsing; and after the Sept. 11, 2001 terrorist attacks, when global markets dived.