The FOMC can loosen interest rate policy, but how much will unsecured interbank lending rates like LIBOR respond? As it stands right now, the Treasury-Eurodollar spread [TED spread], is at 180 basis points, up from 96 basis points (or so — don’t have access to a Bloomberg Terminal). 17 basis points of that rise is a rise in LIBOR. Not the usual response that you expect to loosening monetary policy, but these are unusual times, when credit spreads dominate over monetary policy, even on high quality lending and short term.
It feels like the major global banks don’t trust each other enough to lend to each other short term. This has impacts on mortgage markets as well, such as the ability to refinance mortgages, and resetting mortgage payment rates even on prime mortgages.
Typically the TED spread does not stay this high for long. If the FOMC cut the Fed funds rate to 3%, that might normalize things, but for now they will be content with half measures like temporary injections of liquidity. Now, a 3% Fed funds rate will produce other problems (inflation, lower dollar), and it won’t really solve the overall mortgage credit problems in the short-run, but it is what the market expects by mid-2008. It might help out in problems with the banks that are on the cusp of creditworthiness, and that is what may drive the FOMC to act.