Larry Kudlow

Ben Bernanke's Federal Reserve blew smoke at the markets last week, and markets blew smoke right back. Nothing was solved in terms of the growing global credit crisis, the result of a sub-prime virus that continues to infect money and capital markets everywhere.

Instead of taking aggressive action with a half-point shock-and-awe rate cut, the Fed opted for a timid quarter-point cut. The result was a sharp drop in stocks around the world. It then announced a more generous discount-window lending facility in coordination with global central banks. But that didn't work, either.

Money-market rates continue to rise. And as credit-clogged short-term funding grows shakier, the money-market "spread" against risk-free Treasury paper is widening in both London and New York. Consumer- and business-loan-backed corporate debt declined another $10 billion last week. Since early August, asset-backed commercial paper has dropped over $400 billion, or 34 percent. Euro-denominated loans rose 85 basis points to nearly 5 percent in the credit-frozen London Interbank overnight market (LIBOR), while very short-term dollar-denominated LIBOR rates climbed another 30 basis points.

It's important to understand that the biggest problem in the sub-prime market is the rising default and foreclosure rate. Even though sub-prime adjustable-rate mortgages (ARMs) make up only 4.4 percent of home loans, they represent 43 percent of foreclosures through the third quarter, according to University of Michigan professor Mark Perry. These are the troublemaking loans that were packaged and highly leveraged for sales to institutional lenders throughout the world. But the key point is that ARMs are tied to LIBOR and federal funds markets in London and New York. Thus, if global central banks are to relieve the sub-prime ARM problem, they must get their target rates lower.

All the discount-window rigmarole published by Bernanke & Co. -- aiming at perhaps $50 billion of new bank loans -- is nowhere near a solution. The Financial Times reports that the Federal Home Loan Bank -- a New Deal agency -- pumped in an annualized rate of $746 billion to the private U.S. mortgage sector in the third quarter. Compare that to the Fed's $800 million of discount loans in the same quarter. It's only one-tenth of the home-loan bank's credit injection.

The bottom line remains simple: The Fed must right-size the inverted Treasury yield curve by bringing its 4.25 percent target rate much closer to the three-month Treasury bill, which is trading below 3 percent, and below all the other Treasury rates that are lower than the fed funds rate.

Larry Kudlow

Lawrence Kudlow is host of CNBC’s “The Kudlow Report,” which airs nightly from 7 p.m. to 8 p.m.