Friday, August 17, 2007

The Fed jumps in with one foot 

The Federal Reserve acted this morning, after seeing two pretty large offers on both the 14-day and overnight open market operations. There may be other information they are using, but certainly we're not privy to that. First, it cut the discount rate by 0.5% to 5.75%. The discount window is used by banks that want to borrow from the Fed against high-quality collateral. The Fed normally charges a 1% premium over the federal funds rate for this action; that penalty is now cut to 0.5%. It's also extended the term of the loans to thirty days, which is a substantial deviation from normal practice for primary credit. (Discount window FAQ.) This move is quite sensible in my view: In normal times you want to discourage use of the discount window and keep banks in the fed funds market to hold overall money growth under control. These are not normal times, and the penalty rate for the window has a higher cost right now, so best to reduce it.

Second, the FOMC announced that it had given up the inflationary bias in its statement by issuing a new statement:
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.
I looked and found the statement made on October 15, 1998, when the Fed cut both the discount and fed funds rates by 0.25% to shore up the banking system during the Long Term Capital Management crisis. What they said then:
Growing caution by lenders and unsettled conditions in financial markets more generally are likely to be restraining aggregate demand in the future. Against this backdrop, further easing of the stance of monetary policy was judged to be warranted to sustain economic growth in the context of contained inflation.
Of course, at that time the Fed had just embarked on a set of rate cuts beginning three weeks prior, thinking the economy was cooling under the effects of the east Asian crisis. This time the Fed is leaving a position of putting inflationary risk ahead of recessionary risk that it took only ten days ago, and moving to the opposite position without changing the Fed funds rate.

Some will say it's too little, too late, or perhaps a reaction to the continuing turmoil at Countrywide. The market is happy, yet some will say this is a step towards bailing banks out. But given what it did on August 7th, which was seen by some as acknowledging the squeeze without acting yet upon it, it strikes me as the logical next step.