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August 09, 2007
Fed pumps liquidity into market
It started in Europe when French bank BNP froze $2.2 billion in funds. (Reuters)
"The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly, regardless of their quality or credit rating," it said in a statement.
The European Central Bank immediately injected almost 95 billion euros into the market. This morning, the concerns had spread to the U.S. Fed funds were trading at between 5.375 and 5.5% early in the day according to this Wall Street Journal article. In order to keep the funds rate at its target, the Fed injected $24 billion in a two week repo and $12 billion in an overnight repo. The Journal article states:
The average rate at which the money was lent was also marginally higher than normal, an indication of the strength of demand for cash. "What has happened so far is interesting but not extraordinary," said Ray Stone of Stone & McCarthy Associates, an economics and markets research firm. The Fed, he said, is probably having trouble estimating demand for excess reserves because of the "strain in the credit market" which is adding to the pressure on reserves.
That's probably understating it a bit. What spilled over across the Atlantic was not anticipated today. At best, you might expect that something like this could have happened sometime. It happens that today was the day, and thus was a bit of a surprise.
Are we out of the woods? Not really. Again, from the WSJ:
One risk the Fed faces is that if it injects too much cash, the Fed funds rate would plummet later on to below its target. However, unlike in previous eras, that is unlikely to be interpreted as a deliberate easing of monetary policy. Since 1994, the Fed has announced when it is changing its target for fed funds. After the Sept. 11, 2001, terrorist attacks disrupted markets and sent demand for cash soaring in 2001, the Fed poured money into the system and warned this could send the fed funds rate below its target.
Correct. The same is true here, but on (for now at least) a much smaller scale. This is not an emergency, and indeed the Fed's injection is much smaller than the ECB's injection. Furthermore, the Fed's injection was not aimed at calming a panic, but rather at maintaining the target.
The Fed did the right thing in maintaining the target. If there are no other incidents of banks freezing funds, then this may be enough. But the real question is now, what next?
That's a tough question to answer. It is certainly possible that another bank or hedge fund will find itself in trouble before the mortgage mess straightens itself out. In fact, it's probably pretty likely. It's just that no one knows who, when, or how big. So what is the Fed's role? I keep going back to one of my favorite papers by my fellow Iowa alum Chris Neely. Neely chronicles the use of various methods of providing liquidity: repos, discount window lending, and float, in response to various crises.
Let us not forget the discount window, which really is a misnomer these days. The term refers to the fact that it used to be typically a bit lower than the funds rate. A few years ago, the discount window policy changed. Today, there are actually two discount rates, primary and secondary credit rates. Primary credit is available at a rate of 6.25% and secondary credit at 6.75%. You can read about the specifics here.
Today's intervention was just a ripple in an ocean, but in the event that something more is on the horizon, the Fed needs to remind banks that the discount window is always there to meet their emergency liquidity needs. If anything, the Fed might consider lowering the discount rate to marginally encourage borrowing from that source rather than putting strain on the fed funds market. Lowering the fed funds rate should not be the first reaction to this situation despite the fact that many people will call for it. Lower the fed funds target only if it looks like this is not going to be contained by the financial markets.
This is not (yet) a crisis on the scale of others we have seen. Whether more injections from the Fed will be required to prevent counterparty risk and systemic risk remains to be seen, though I am confident that they will supply the liquidity if required. As for the funds rate, the carnage at the CBOT suggests that either others are not as confident that this will be contained, or they believe that the Fed is on the verge of giving in. The first is a possibility that cannot be ruled out. The second is, I hope, a misguided notion.
Still, it was quite a significant event that took place today.
UPDATE: Mark Thoma must have sneaked a peak at the lecture I plan on giving my intermediate macro class on day one this fall. Very nice exposition.
UPDATE 2: Felix Salmon notes this Wall Street Journal piece that says the subprime mess may have extended its reach into the money market. That would certainly raise the risk that this will cause problems in the wider world. That is not something that you like to see.
Posted by William Polley at August 9, 2007 02:47 PM
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