Fed Cuts the Discount Rate

Before everyone gets all worked up about the Fed "caving" to Wall Street, lets review exactly what the Fed accomplished today. The Fed responded to increasing liquidity problems by reducing the rate it charges at the discount window by 50 bps. The discount rate is still 50 bps above the Fed Funds rate and lowering that rate is not nearly as significant as a change to the Funds rate. Here is a great explanation of the discount window courtesy of Greg Ip at the WSJ:

The discount window is a channel for banks and thrifts to borrow directly from the Fed rather than in the markets. Until a few years ago, the discount rate was set below the fed funds rate and loans were subject to numerous conditions.

Banks were reluctant to access the window because it was associated with a stigma usually reserved for distressed banks. A few years ago the Fed overhauled the discount window to try and alleviate that stigma; the rate was then set one percentage point above the funds rate and subject to far fewer conditions. In spite of that, discount window borrowing has remained paltry.

Discount lending averaged just $11 million in the week ended Aug. 15. Although that was up from $1 million in the prior week it was puny compared to the billions of dollars the Fed has regularly injected into the financial system through open market operations.

Fed officials hope that reducing the penalty rate associated with the window and lengthening the term of loans to 30 days from one further lifts the stigma and gives it a tool to supplement open market operations for reliquefying markets.

Yes, folks $11 million/day of lending through the discount window last week. The discount rate is virtually meaningless at those levels and it would be hard to construe lowering the rate as "caving" to Wall Street. In truth lowering the discount rate should only partially help to "reliquefy" markets (though it could save Countrywide) but perhaps more importantly, it signals to the markets that the Fed is moving away from its "inflation" bias. Until today all indications from the last Fed statement and the comments from Mr. Poole indicated that the Fed was still primarily focused on inflation. But, in the Fed's statement it did acknowledge that threats to growth have risen:

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.

So the Fed cut the rate at a window that has gone virtually unused and issued a statement that shows that it is not out in left field ignoring the potential fallout from the credit crunch. But, it didn't change the Fed Funds rate, nor did it hint at a future cut. The Fed still believes that this is primarily a liquidity issue though it is admitting that downside risks to growth have increased. Let us not forget that Bernanke is a prolific researcher of the Great Depression, which is acutely relevant to the current credit crunch:

``The relevance of Bernanke's work to today is that it helps him tread the fine line of allowing individual investors - - and firms, if necessary -- to fail while avoiding credit market gridlock,'' said Joe Mason, professor of finance at Drexel University in Philadelphia. ``The message from the recent interventions is that there is no gridlock.''

As Bernanke and the Fed strike the balance between orderly credit markets and the unwinding of years of cheap credit, we are left wondering if the potential collapse of Countrywide was a factor in today's shift. I was surprised by the quick turnaround in the Fed's stance on growth, and the psychological damage to markets of the top mortgage lender in the US going under cannot be ignored. It now looks far more likely that the Fed will find cause to cut rates before year end. The key will be if the hard economic data gives them the flexibility to cut if needed. If we receive low core PCE data and another uptick in unemployment the Fed will have the leeway to accomplish the cut without looking like it is bending too much to Wall Street.