Until yesterday morning, Ben Bernanke, the chairman of the US Federal Reserve, was the cartoon villain for many traders and investors on Wall Street. At about 8.15 New York time, he became a hero.

Since the crisis in US credit markets deepened two weeks ago, a heated debate has been under way between what might be called the bailout crowd on the one side and the tough-love brigade on the other.

From Wall Street, and even more noisily, from a cast of prominent TV financial pundits, a rising chorus has been shrieking for help from the Fed. They have pleaded with the Fed to cut interest rates to help financial institutions in trouble and provide a reassuring way out of the panic that has gripped markets this troubled summer. On the other side, Wall Street’s critics have argued that a Fed rate cut would be disastrous. It would reward, they said, irresponsible behaviour by financial institutions that wildly over-invested in dodgy mortgages and other markets in the past few years.

Yesterday, with its first interest rate cut for four years, the Fed appeared to have a change of heart. However, Mr Bernanke did not follow the advice of the bailout crowd and cut its main monetary policy rate, the Fed Funds rate, the linchpin of the financial system, the rate at which banks lend to each other overnight. Instead, he took half a percentage point off the discount rate, the rate at which the Fed lends money directly to banks in its capacity as a lender of last resort to financial institutions in distress.

This unusual move seems to have had two main objectives — an immediate, practical one and a symbolic one. For most of the last two weeks, its critics notwith- standing, the Fed has not been standing idly by. It has been injecting funds into the banking system through increases in its regular open market operations with banks.

This approach, rather than a broad rate cut, reflects the view of Mr Bernanke and his colleagues that the current problems are about liquidity, not solvency. The damage from the US sub-prime mortgage market has created a crisis of confidence in many financial institutions. Although most bank balance sheets are probably in reasonable health, uncertainty has led to a panicky reluctance by banks to engage in the usual transactions that keep the financial system fluid.

The Fed had been betting that its heavy injections of cash would stop the panic. But this week the financial dislocations produced by this uncertainty have intensified and the central bank has watched with mounting concern as some truly remarkable things have happened.

Wild movements in currency markets suggest banks and hedge funds are desperately unwinding once profitable cross-currency trades to meet demands for cash. In money markets, according to data from the New York Fed, some banks this week had actually been offering to lend money overnight to other banks at a zero rate of interest — an absurdity (why take the risk of lending money to another bank at zero when you can leave it in your own vaults?).

This weird anomaly seems to suggest some institutions are in real distress that is yet to be revealed.

Perhaps worst of all, in the past few days, banks were starting to signal a sharp loss of confidence even in the trading of debt of financially sound companies. Interest rates on commercial paper — the short-term debt issued by corporations — shot up way above the yields on Treasury bills as banks fled in panic to the safe haven of government securities.

All this indicated to Fed officials that they had not done enough to ease the panic. So late on Thursday night they considered their options. The upshot was a cut in the discount rate to 5.75 per cent.

Banks do not usually like to borrow directly from the Fed. Going to the “discount window” carries a stigma that suggests real difficulties. Lowering the rate at which they can borrow in this way helps to diminish the stigma. The hope at the Fed is that more of the financial institutions that need assistance will now come to the central bank for help. The Fed also announced it was significantly increasing to 30 days the term of these discount rate loans, hoping to reassure banks that they had access to a stable source of funding.

The Fed clearly hopes these unusual moves will be enough, and that it will not have to ease monetary policy. But, tellingly, there was another side to the Fed’s action yesterday. The central bank also signalled that it understood that its limited action might not in fact work. In the statement it issued accom- panying the discount rate cut, it hinted that a real interest rate cut — to the Fed Funds rate — might yet be needed.

This comment represented a shift in the Fed’s assessment of the overall US economy. Hitherto, it has insisted that, despite the market problems, inflation was still the bigger threat. But yesterday it said the problems in the credit markets could significantly impede growth. That is code for saying it is ready to cut interest rates across the board if things do not get noticeably better soon. And that would make Mr Bernanke an even bigger hero on Wall Street.

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