Some analysts, and perhaps the market, seemed to view Friday’s cut in the Federal Reserve discount rate as a first step in lowering interest rates generally. That view may prove to be correct, though I’m inclined to look first for an explanation in terms of the narrow tactical challenges of managing current liquidity needs.
Unlike many other central banks, the U.S. Federal Reserve does not directly control its primary policy target, the federal funds rate. Instead, as I described in more detail last week, the Fed makes daily changes in the volume of outstanding Federal Reserve deposits in a way that it expects to be consistent with its objective of achieving a particular value for the rate at which these deposits are lent overnight from one institution to another on the federal funds market. Their objective is defined in terms of a volume-weighted average of all the transactions during the day (referred to as the “effective” fed funds rate), with the target for the effective rate currently declared to be 5.25%. The Fed usually makes at most one such intervention early in the day, and is then content to allow the actual fed funds rate at which banks choose to borrow or lend to each other fluctuate above or below the target. Often at the end of the day, and especially on the last day of the two-week period in which banks have to complete the satisfaction of their required average holdings of reserves, one will see the fed funds rate spike up, if some bank finds itself unexpectedly needing funds at a time when everybody else is finished trading for the day, or fall to practically zero, if some bank unexpectedly finds itself with excess funds that nobody else is interested in borrowing. As William Polley noted, this last week these intraday fluctuations have been particularly dramatic, with one trade last Wednesday (a settlement day) as high as 6% and another on the same day for only 0.25%.
Why does the Fed allow so much intra-day variability in the interest rate it is intending to target? One reason is that the Fed does not want to be in a position of subsidizing individual banks that choose to make unusually risky investments. If a bank knew that, no matter what it did, it could always obtain an unlimited source of funds at a 5.25% rate, the bank would have an incentive to borrow a huge quantity of such funds and use them to make higher yielding, but potentially quite risky, investments. If instead the bank must rely on a competitive lending market for its overnight funds, it knows that the more it tries to borrow and the riskier its portfolio becomes, it will have to pay a higher rate to borrow those overnight funds than will another bank with a more solid balance sheet. The Fed intentionally allows different banks, in different circumstances or at different times of the day, to pay a higher or lower rate for fed funds than do other banks, as one way of making sure that banks face immediate consequences of any extra risk-taking.
In addition to choosing a particular target value it hopes to see for the effective fed funds rate each day, the Fed has a strong intention to prevent a full-blown liquidity crisis of the type that was seen relatively frequently in the nineteenth century, but have been successfully avoided in the United States since the founding of the Federal Reserve in 1913. I am using the term “liquidity crisis” here in a narrow and precise sense to refer to a situation in which the value of banks’ assets would be more than sufficient to pay off all their customers and creditors if these assets could be sold off in an orderly market, but may be insufficient if those assets must be immediately liquidated at fire-sale prices. Such episodes have been avoided since 1913 because the Fed stands ready to play the role of a lender of last resort, offering to create reserves in whatever quantity may be necessary to ensure an orderly liquidation of assets.
Of course, there is an inherent tension between the goals of serving as lender of last resort and making sure that banks are disciplined for risky behavior, and this tension is at the heart of the current policy dilemma facing the Fed. To help to achieve these twin objectives, the Fed has a separate tool, the discount window, through which it offers to lend directly to banks, temporarily giving them newly created reserves while holding high-quality assets as collateral for such loans. Again there have to be some institutional checks to prevent excessive risk-taking for banks using this facility. Historically, the Fed achieved this by placing additional limitations and regulatory oversight on banks that borrowed too much or too frequently at the discount window. Partly as a result of these, the discount window acquired a certain stigma, where many banks chose to pay even an arbitrarily high fed funds rate rather than try to borrow anything directly from the Fed itself.
In January 2003, the Fed decided to change this practice, declaring an end to the administrative restrictions on discount window borrowing, allowing and even encouraging banks to borrow as much as they wanted from the discount window. What was supposed to prevent banks from abusing this privilege was the fact that the discount borrowing rate was set at a value 100 basis points above the fed funds target. The idea was that the system could automatically put a ceiling on the effects of any short-run liquidity crunch, while ensuring that any bank that routinely acquired its funds from the discount window would be at a strong competitive disadvantage relative to banks that simply used the fed funds market.
We had the first real test of this new system August 10, when the Fed was worried about the possibility of an unfolding liquidity event, if not actual crisis. This was associated with a significant volume of offers to borrow fed funds at 6%, which would be 75 basis points above the Fed’s current 5.25% fed funds target, but 25 basis points below its 6.25% discount rate. Not surprisingly, banks would prefer to borrow at 6% from another bank rather than pay 6.25% to the Fed. Of the $18.5 billion increase in the average level of Federal Reserve deposits over the week ended August 15, only $20 million came from increased discount window borrowing, and total average discount window borrowing remained a quite modest $271 million.
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.
Now, it may well be that they separately later decide that a lower target fed funds rate also makes sense in the current situation. Indeed, I was on record urging the Fed to cut the fed funds target, and predicting that they would indeed choose to do so, well before the excitement of the last two weeks. It’s just that now I seem to have a lot more company in that advice and prediction.
Nevertheless, I believe that in changing the discount rate while holding the fed funds target constant for now, the Fed did exactly what it wanted to do, rather than some kind of half-way measure with another objective in mind.