Will a new, improved discount window solve our problems?
Yesterday, the Federal Reserve announced that it would (1) reduce its target for the fed funds rate by 25 basis points, lowering the target from 4.5% to 4.25%, and (2) reduce the interest rate it charges for borrowing from the Fed discount window by 25 basis points, lowering the latter rate from 5.0% to 4.75%. When I wrote that yesterday’s huge stock market decline was difficult to attribute to investors’ surprise about (1), several readers wanted to claim that, no, the real news was (2), in that many traders expected the Fed to cut the discount rate by more than it reduced the fed funds target.
The graph above plots the total volume of borrowing from the Federal Reserve over the last year. Note well the scale– last week total borrowing came to 342 million dollars. To put this number in perspective, today the Federal Reserve injected $27.75 billion dollars in reserves in the form of traditional open market operations, a number that exceeds last week’s average daily borrowing by two orders of magnitude. Even the spike in borrowing in September only amounted to a little over $3 billion, still barely one-tenth the size of today’s open market operations. Twenty-five basis points on a billion dollars borrowed for 30 days comes to about $200,000. The claim that this could account for a 2.5% drop in the total value of the U.S. equity markets strikes me as, shall we say, creative.
But let’s hear the case, such as it is. WSJ Real-Time Economics quotes an analyst from the Bank of Nova Scotia as follows:
[The Fed] maintained the discount rate spread of [a half percentage point], which either indicates they don’t regard the strains in the money market as a significant risk, or that an aggressive reduction won’t do much good. Neither explanation does much for the market’s confidence, and it was no surprise to see equities tumble immediately after the announcement.
Well, unquestionably the Fed does see the strains in the money market as a significant risk. Evidently there are those who entertain the hope that the Fed could find two separate tools to achieve two separate ends. The first tool– the traditional instrument of monetary policy– is to adjust the total quantity of reserves available to the banking system so as to achieve a particular target value for the fed funds rate, the rate at which one bank lends to another overnight. When one describes a traditional monetary policy action as “providing liquidity,” this is what we are discussing.
But there appears to be a widespread belief that the Fed needs a second tool in order to achieve a second policy objective, which is somehow to eliminate the gridlock in financial institutions resulting from huge holdings of assets that no one seems willing to buy. Perhaps, the thinking seems to go, adjusting the spread between the discount rate and the fed funds rate could be a tool to accomplish this.
I am inferring that the Fed itself may also have been musing along these lines, in that it today announced creation of a term auction facility. The basic idea is that the Fed will specify a certain maximum amount that it would like banks to borrow. It intends to lend up to $20 billion for a 28-day term on Monday, and lend up to an additional $20 billion for a 35-day period on December 20. Potential borrowers will bid an interest rate to receive this loan, with I presume each $20 billion going to the highest bidders. Banks must also provide collateral for these loans.
The objective is clearly not just to get $40 billion more in reserves into the banking system next week– an open market operation could accomplish that just fine. The objective must be to get the reserves into the hands of those particular banks that want them most. Of course, those same banks could be getting them right now through the discount window, but choose not to, perhaps because of the stigma, or perhaps because of the financial penalty charged for discount borrowing relative to borrowing on the fed funds market from other banks. In effect, the term auction facility would reduce the spread between the discount rate and the fed funds rate to however low it needs to be in order to motivate $40 billion worth of borrowing next week.
The other thing the facility accomplishes is allow the Fed to accept lower-quality collateral from borrowers than its rules require for open market operations conducted through repurchase agreements. If there is an effect of the facility, I would think that this would be the mechanism. What may matter is not the reserves put in the system, nor who gets those reserves, but the troublesome assets temporarily taken off some institutions’ balance sheets.
We might then logically ask, what’s the source of the unwillingness of investors to purchase these CDOs and MBS? I would have thought that the answer has something to do with the market’s current evaluation of the risks. By agreeing to hold some of the problematic securities, the Fed is essentially offering to absorb some of that risk.
One might argue that in the best (and perhaps most likely) case, the Fed will suffer no loss, and possibly through its actions avert a very nasty cycle of bankruptcies and defaults. In the worst case, those defaults will come anyway, with the Fed absorbing some of the losses along with everybody else. But the way that the Fed would absorb these losses is by being forced to create more money. And, the argument might continue, if we had a financial crisis of the magnitude that produced a loss on the offered collateral, we’d be in a situation with a serious risk of deflation, precisely the circumstances in which we’d want some extra money creation. Win-win.
Or so the thinking may go. But I hope that Bernanke has also pondered the following– What would happen to foreign exchange markets and foreign demand for U.S. assets under the second happy scenario? There certainly is plenty of historical precedent for financial crises you can’t inflate your way out of– southeast Asia in 1997 comes to mind as one recent example.
Or if you’d like a second or third opinion, I recommend Felix Salmon, Steve Waldman (hat tip: Economists View), or [late update] Yves Smith and [later update] Accrued Interest. Greg Ip has some information that the Fed wanted to communicate to the public but apparently was unwilling to do so “on the record”. And doubtless you will soon be able to find any number of alternative perspectives from our readers in the comments section below.