Stay the course

The sudden tightening in credit markets has pushed the Federal Reserve into a rare about-face. After declaring Aug. 7 that its main concern was the risk of sustained inflation, over the last two weeks it has pumped billions of dollars into the economy and slashed the interest rate it charges banks for short-term loans.

The moves have yet to ease the credit crunch, however. Investors continue to flee risk as if it were newly toxic, spooked by the extent to which the sub-prime lending collapse has spread to banks, hedge funds and even money markets around the globe. Demand was so great for three-month Treasury bills -- the definition of a safe investment -- that the yield shrank 19% on Monday.

Now the question is whether the Fed should do more, by lowering the target for interest rates that banks charge each other for short-term loans. This Fed funds rate influences interest rates generally and economic growth. Opponents of the move say it would save investors who should suffer the consequences of their bad choices.

Wall Street certainly will use any excuse to clamor for easier money. But one of the main reasons the financial markets are in a fix today is that credit was too cheap for too long, which prompted lenders to take on irrational risks. Another reason is runaway financial innovation, which threw traditional lending standards out the window. That wouldn’t have been such a bad thing had the goal been long-term affordability, but new ways of combining loans into packages for sale made affordability moot by hiding the risk of individual loans.

Regulators have belatedly turned their attention to the, ahem, creative instruments that have spread the pain of foolish lending along with the joy of homeownership. That scrutiny should help restore some of the confidence lost both by investors and lenders. Better yet, the market would punish investors who bet on cleverly designed assets whose value wasn’t clear. It’s just that sort of investment that’s bedeviling some large hedge funds, and if it causes them to fail, so be it.

The Fed, meanwhile, has appropriately shifted its concern from inflation to the ability of financial markets to function. Its recent moves have been well-calibrated, aimed at buying some time for lenders, such as Countrywide Financial Corp., that have been caught in the market’s crisis of confidence. It should maintain that course as it tries to shield the economy at large from the collateral damage of the sub-prime meltdown.