The financial health of Lehman Bros, America’s fourth largest investment bank, grabbed the market’s attention for a second day, driving Wall Street down. With the Dow losing 100 points on top of Monday’s 131 point fall.

Oil prices fell $US4 a barrel, leading other commodities, such as gold, copper, grains, sugar and energy lower in the US, after they had traded higher in Europe and Asia.

Worries about Monday’s weakness was based on the downgrading of credit ratings of Lehman Bros, Merrill Lynch and Morgan Stanley, which also tipped over into Australia yesterday where bank shares fell sharply, led by big falls for Babcock and Brown and Macquarie.

Rumours of a $US4 billion capital raising by Lehman Bros in the Wall Street Journal added to the impact of the downgrade and worries soared. Lehman Bros said overnight it has $US40 billion in cash, hasn’t been to the Fed’s market window to borrow since 16 April and was well placed. However, investors didn’t listen and Lehman Bros hit a five year low on Wall Street but then rebounded after disclosing the news of the cash and the lack of borrowing from the Fed. The shares closed down 7% on the day.

Now the US Federal Reserve and it’s chairman, Ben Bernanke, have to keep a very close eye on Lehman Bros on the chance that a repeat of the run on Bear Stearns develops, draining valuable liquidity and forcing some sort of official action or a repeat of the March 17 rescue. We will know the week after next when it reports its second quarter figures.

The concerns about Lehman overshadowed Bernanke’s major speech, made from the US to a conference in Europe, that the Fed’s policy stance had changed.

Bernanke signalled that interest rates were on hold and that there was a major policy switch towards concentrating on inflation and getting the value of the US dollar higher to counter rising cost pressures from rising food and oil prices, among other things.

It’s all about leaving rates on hold and helping stabilise the US dollar: Federal treasury Secretary Hank Paulson had emphasised America’s commitment to a strong dollar in comments in the Middle East the day before. Now the Fed chairman was making sure the change in policy was well understood.

So if the Fed has to move to stabilise markets made nervy by more problems from the banking and financial sector, or from the continued slump in house prices, will that be at the expense of “ensuring that the dollar remains a strong and stable currency”?

That’s the policy dilemma, which makes that of our Reserve Bank as it tackles inflation, seem a bit simple, really.

Peter Fray

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