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August 17, 2007
Fed cuts discount rate
Note: Earlier today my web host had a DNS meltdown. Since I was able to telnet to the site, I typed a makeshift "post" directly into the main blog page, knowing that I might not get a chance to log in until tonight. Now that the DNS issue has been fixed, I am putting the content of that "post" into a proper post. I have also added links to the Fed statements.
If you are reading this, then the DNS issue has resolved. However, I will need to be away from the computer for a few hours this afternoon, so I wanted to get a message up for when things are back to normal.
The irony is that even with all the shake up today, there isn't a whole lot to say that hasn't already been said. The Fed lowered the discount rate (something that I suggested a while back), but did not act to lower the fed funds target. They did, however, issue a statement which announced the new assessment of risk being more tilted towards lower growth than higher inflation. This does pave the way for a change in the target down the road if the need arises. I think it's fairly obvious that they want to hold off on that. If they didn't want to hold off, they would have just gone ahead and done it today. But I think that they correctly realize that we're moving into a period where the decisions are going to be made on a day-to-day basis. This statement, which is rare in announcing a shift in the bias between meetings without a change in the target, is simply an acknowledgment of that fact.
Remember, since the discount rate is a misnomer (it's really a premium rate now), the action today simply lowers the penalty that banks pay to borrow from the Fed directly. As Bagehot famously said, the appropriate thing to do here is to lend freely at a penalty rate. They're still doing that. It's just that in this circumstance a lower penalty is warranted so that if a larger liquidity squeeze develops banks might be encouraged to go to the discount window sooner. I wasn't sure they would do it--thinking that it could cause more panic. That didn't seem to happen, and I think the reason is that in the last few days more market participants have come to the realization that the Fed was going to do "something" and so it wasn't really all that unexpected, even though what they did was a bit unusual.
One final comment about the many commentators who have mentioned the lower effective fed funds rate. I covered this in my previous post, but here's one other thing to consider. I think in this case, it would be more useful to know what the median fed funds rate is. The effective rate is a weighted average and is being pulled down by trades at close to zero, which I think are due to the last trades of the day being excess reserves and have a lower reservation price. I don't think the median rate is computed, but if it was it would be more illuminating.
I still haven't come over to the camp that says that a rate cut in September is a sure thing. Everything I see is telling me that the Fed is doing whatever it can to avoid it. It may not be possible, but they will see how this cut in the discount rate plays out and take it from there.
There will be a rate cut if it looks as if the present situation is spilling over into overall gross domestic private investment (e.g. if commercial real estate, which has been stronger, begins to show signs of failing). That's when a cut in the target fed funds rate (which would lower the effective rate, as well as the high end of the range and the median) would be called for. The discount rate action today was not aimed at stimulating the economy, but rather to provide a marginally more attractive liquidity cushion.
I'm sure there will be lots of good commentary over the weekend and a highly anticipated opening of the markets on Monday.
UPDATE: James Hamilton offers the following excellent observations with which I completely agree.
I think that the Fed would prefer to rely on the automatic functioning of the discount window, rather than the multiple aggressive open market operations that we saw on August 10, to respond to the kind of challenges that have arisen in markets over the last few weeks. If the Fed really wants banks to go to the discount window rather than bid the fed funds rate up to 6% in response to these kinds of pressures, it makes sense to offer to lend through the discount window at the new lower rate of 5.75%, as well as extend the terms of these loans to 30 days, as the Fed did this Friday.
I believe that the Fed adjusted the discount rate rather than the target fed funds rate not because it's a back-door way to lower interest rates, but instead in order to address the specific policy objective of making sure the discount window gets used as part of the automatic response to the kinds of liquidity pressures that have been bobbing up these last two weeks.
Posted by William Polley at August 17, 2007 6:09 PM
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Comments
Well no body has told me I am dead wrong yet, so here is something to think about. The Fed not only lowered the Discount Rate, it extended the term to 30 days from overnight.
It seems to me that this radically changes the function of the Discount window. As an example it looks like Countrywide fully tapped the $11.5 billion in credit it arranged. Well a fully open renewable source of cash by the people who print the cash seems like a nice way of staving off a liquidity event. And for Countrywide that is what it seems to be, it doesn't appear to have been nearly as exposed to sub-prime as say New Century or the host of other lenders that crashed and burned.
This all looks like a sensible solution if what we are facing is a liquidity event and from my point of view that is exactly what is going on. A small spike in foreclosures that was the natural result from a strongly rising housing market to a steady state one (I don't buy the multi-year decline model) was overinterpreted and the liquidity spigot was simply slammed shut in a way that was not justified by the underlying performance of the housing market.
On the other hand Dean Baker and Calculated Risk might be right on the money here. I guess we will see.
Posted by: Bruce Webb at August 18, 2007 3:19 PM
Credit spreads have widened, and credit availability at any price has declined. Doesn’t that mean that, if the Fed were to leave the FFR unchanged, they would effectively be tightening, from a macroeconomic point of view? The FFR has little direct relevance to the real economy; it has indirect relevance because it helps determine loan rates, and it is relevant as an indicator because it is correlated with various rates that are directly relevant. But ultimately, monetary policy only affects the real economy through retail interest rates, credit availability, housing values, corporate bond yields, and so on. All these variables have deteriorated relative to the FFR. So if 5.25% was the macroeconomically optimal level for the FFR a month ago, it couldn’t possibly still be the optimal level today – even if the risks hadn’t shifted toward lower growth, which, according to the statement, they have. Therefore, it seems to me, if the Fed leaves the FFR at 5.25% in their September meeting, they are either making a mistake or acknowledging that they made a mistake earlier by not raising the rate further.
Posted by: knzn at August 19, 2007 2:57 AM
Bruce, you are correct about the extended term, and I'm pretty much in agreement with you on the rest.
Knzn, I see your point. Yet, I think it is an open question as to whether the current funds rate of 5.25% is out of line with the other variables in the longer view. If opening the discount window a little wider helps the intermediaries arrange an orderly workout to all of this, then it could be argued that the funds rate does not need to be lowered.
I think they are going to hold on to that possibility for as long as they can.
Posted by: William Polley at August 19, 2007 11:14 PM