The Fed’s ‘clear mes­sage’

The Washington Times Weekly - - Editorials -

In an­nounc­ing Aug. 17 its de­ci­sion to lower the dis­count rate, the in­ter­est rate the Fed­eral Re­serve charges mem­ber com­mer­cial banks for bor­row­ing at its dis­count win­dow, the Fed has de­vised a creative, in­ge­nious re­sponse to a spe­cific prob­lem. The Fed had spent the pre­vi­ous week in­ject­ing tens of bil­lions of dol­lars into the overnight mar­ket to pre­vent the fed­er­al­funds rate from ris­ing above the Fed’s tar­get level of 5.25 per­cent. The fed­funds rate is the in­ter­est rate that banks charge each other for overnight loans.

This rate had been ap­proach­ing 6 per­cent as banks be­came leery of lend­ing to each other; no­body knew the oth­ers’ ex­po­sure to subprime and other in­creas­ingly sus­pect se­cu­ri­ties. De­spite the huge in­jec­tions of dol­lars by the Fed and other cen­tral banks, the fi­nan­cial mar­kets re­mained on the boil.

When the Fed an­nounced on Aug. 10 that it in­tended to pro­vide the nec­es­sary dol­lars to en­force the fed-funds rate of 5.25 per­cent, it point­edly noted that, “[a]s al­ways, the dis­count win­dow is avail­able as a source of fund­ing.” How- ever, banks his­tor­i­cally have been re­luc­tant to bor­row at the dis­count win­dow, whose in­ter­est rate is higher than the fed-funds rate, be­cause it might be taken as weak­ness. The Fed has tried to dis­pel that fear in sev­eral ways. When the Fed low­ered the dis­count rate by half a point to 5.75 per­cent on Aug. 17, it also in- creased the loan pe­riod from a sin­gle day to “as long as 30 days, re­new­able by the bor­rower.” Not only is the Fed dis­count win­dow avail­able “as al­ways,” the cen­tral bank ef­fec­tively said, but to en­cour­age its use, the Fed of­fered much bet­ter terms to prospec­tive bor­row­ers. The Fed fur­ther em­pha­sized that it would “con­tinue to ac­cept a broad range of col­lat­eral for dis­count win­dow loans, in­clud­ing home mort­gages.” A Fed-ini­ti­ated con­fer­ence call later made clear that bor­row­ing from the Fed’s dis­count win­dow would be con­sid­ered a sign of strength, not weak­ness.

While in­vest­ment banks and hedge funds can­not di­rectly bor­row from the Fed, they can take their unim­paired mort­gage-backed se­cu­ri­ties to com­mer­cial banks as col­lat­eral for loans. Those com­mer­cial banks can then pledge those se­cu­ri­ties as col­lat­eral at the Fed’s dis­count win­dow. The Fed “re­ally wanted to drive home the point that if [bankers] were com­plain­ing about not be­ing able to bor­row money against liq­uid, high-qual­ity se­cu­ri­ties — mort­gages — [then] we [now] have no more ba­sis for com­plaint,” a banker who par­tic­i­pated in the Fed’s con­fer­ence call told the Wall Street Jour­nal. “We were all given a clear mes­sage.”

Thus, the Fed has cre­atively aimed its re­sources at a spe­cific liq­uid­ity prob­lem with­out wors­en­ing the prob­lem of moral haz­ard, which could oc­cur if the fed­funds rate were cut.

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