A significant statement
The Fed cut the discount rate by 50 basis points on Friday to 5.75%, a largely irrelevant move in terms of interest rates with Fed Funds trading in the low 4’s. However, the Fed’s accompanying statement was very important, and certain other aspects of the Fed action appear quite significant:
To promote the restoration of orderly conditions in financial markets, the Federal Reserve Board approved temporary changes to its primary credit discount window facility. The Board approved a 50 basis point reduction in the primary credit rate to 5-3/4 percent, to narrow the spread between the primary credit rate and the Federal Open Market Committee’s target federal funds rate to 50 basis points. The Board is also announcing a change to the Reserve Banks’ usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower.
These changes will remain in place until the Federal Reserve determines that market liquidity has improved materially. These changes are designed to provide depositories with greater assurance about the cost and availability of funding. The Federal Reserve will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets. Existing collateral margins will be maintained. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York and San Francisco…
Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.
Voting in favor of the policy announcement were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Richard W. Fisher; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Michael H. Moskow; Eric Rosengren; and Kevin M. Warsh.
There are a number of very interesting aspects to this statement. One of the less-remarked elements is that the Fed now says that it stands ready to provide in effect term loans to borrowers in the mortgage business like Countrywide, and will value a substantial portion of its collateral at 100%. That would appear to be significant to companies in a market who have found it hard to borrow overnight money in recent days. Bloomberg characterized the rate cut as follows:
The Federal Reserve lowered the interest rate it charges to banks and acknowledged for the first time today that an extraordinary policy shift is needed to contain the subprime-mortgage collapse that began roiling the world’s financial markets two months ago.
The Fed, in a surprise announcement in Washington, cut the so-called discount rate by 0.5 percentage point, to 5.75 percent. Policy makers dropped language indicating their bias toward fighting inflation, and instead highlighted a rising threat to economic growth. That suggests officials will reduce their benchmark rate when they meet Sept. 18, economists said.
“This telegraphs their intention to cut rates at the next meeting,” said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. “This discount rate cut calms the market and helps financing.” This is the first reduction in borrowing costs between scheduled meetings since 2001, and Ben S. Bernanke’s first as Fed chairman…
The Fed said while recent reports indicate economic growth continues at a “moderate pace,” risks to the expansion have risen “appreciably.” The statement is a marked change from just 10 days ago, when officials kept rates unchanged and reiterated that inflation was their “predominant” concern.
“Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth,” the Federal Open Market Committee said today. “The committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects.”
This is a indeed a remarkable change, a shift away from inflation as the “predominant” concern to the “deteriorated” conditions of the financial markets in less than two weeks. We also note the comments of Stephen Stanley of RBS Greenwich Capital to the effect that the conventional wisdom now fully anticipates a rate cut at the September meeting, a striking turnaround from ten days ago:
“At the risk of lifting the wizard’s curtain and ruining this gesture, I need to point out that a cut in the discount rate is not an ease, and in fact from the standpoint of mechanics is barely relevant, as borrowing at the window was minimal through Wednesday. The Fed is no doubt hoping to capitalize on the past. Prior to 2003, when the discount rate was lower than the funds rate, cutting the discount rate was the most powerful tool in the monetary policy tool belt.
Indeed, prior to 1994, when the Fed began announcing changes in the funds rate target, a discount rate move was the ONLY move that was explicitly announced. Many market participants will think of the discount rate cut in those terms, which is not the correct way to consider it. Instead, this should be thought of as another (indeed, probably the last) intermediate step short of an ease.”
We note that the Fed’s action at the open is reported to have wiped out a number of bears who bet heavily on the short side — their contracts’ settlement values were negatively impacted by the timing of the move at the open of trading. The Fed has a complex job. Among other things, it has to ensure the orderly functioning of financial markets, which often means benefitting some of the wise guys in the markets. At the same time it has to find ways to punish some of the speculators who ride its coattails. It would appear that the Fed did a little of both today.
More importantly, the Fed made clear for the first time that it will attempt to effectively deal with the kind of unprecendented volatility that has caused money center commercial and investment banks to have value swings as much as 25-30% in just one week.