Sunday, August 19, 2007

The Federal Reserve's Discount Rate Monetary Policy

On Friday, August 17, 2007, the Federal Reserve Board announced that it had cut its discount rate from 6.25% to 5.75%. The Dow Jones Industrial Average closed up 233 points. Many commentators described the Fed's action as "symbolic." But there's nothing symbolic about a day where the Dow closes up 1.8%. Or is there?

The discount rate is the interest rate that the Federal Reserve charges to member banks when they borrow from the Fed. Banks often borrow to meet reserve requirements. Members of the Federal Reserve System are required to maintain certain minimum reserves of money in accounts with the Federal Reserve Banks or in vault cash. These reserves are meant to strengthen the banking system, by setting aside some money that is available if needed. The funds used to meet reserve requirements are called "federal funds," which is where the term "fed funds rate" comes from. Banks needing reserves typically take out loans from other banks, and the interest rate they pay is the fed funds rate.

The Federal Reserve System member banks can also borrow from the Fed. The interest rate they pay for direct loans from the Fed is the discount rate. Banks generally avoid borrowing from the Fed. In part, this is because they think borrowing from the Fed signals weakness--that they cannot borrow from the marketplace and must turn to the government. Also, the discount rate has been higher than the fed funds rate, so borrowing from the Fed costs more.

Because banks usually borrow very little from the Fed, a lower discount rate contributes little or nothing to their short term profitability. When it announced the lowering of the discount rate, the Fed encouraged member banks to borrow from the Fed and stated that doing so would be seen as a sign of strength, not weakness. Thus, the Fed wanted to make clear that it stood ready to make loans to member banks.

It's unclear how many member banks took up the Fed's offer. The fed funds rate has been running lower than the new, lowered discount rate much of the time. This is a consequence of the liquidity infusions that the Fed and other central banks have been making during the last couple of weeks. The fact that the fed funds rate is often running lower than the discount rate suggests that there isn't a systemic liquidity crisis. Moreover, the new discount rate of 5.75% is still a half a point higher than the Fed's targeted fed funds rate of 5.25%. This leaves member banks with little reason to borrow from the Fed.

It's possible that smaller banks, which have fewer resources than the big banks, might line up at the discount window. However, there isn't much indication that many smaller banks are in distress. They generally aren't big enough to be major players in the derivatives market/hedge fund sand lot. Nowadays, they might see that as a good thing..

The news headlines point toward hedge funds and mortgage companies as the big losers. But they can't borrow from the Fed. And the banks aren't enthusiastically lending to them any more, unlike three months ago. So the discount rate cut isn't likely to help the folks who are hurting the most.

Then, why did the Dow pop 233 points skyward?

The answer probably stems from the fact that markets are based on differences of opinion. One person may think an asset is worth more than the current market price, and buy it. Another may think the asset is worth less than the current market price, and sell it. If we didn't have differences of opinion, we wouldn't have markets. You can see this with respect to CDOs today. Everyone who owns one wants to sell, and no one wants to buy. You can't get a cash bid for the little buggers, so they don't trade. Because there's no difference of opinion, there's no functioning market.

In the stock markets, however, there is a pool of optimists and a pool of pessimists. The optimists tend to see the sunny side of the news and buy. The pessimists tend to see clouds and sell. The dual-sided nature of the market isn't necessarily evenly balanced. From about July 2006 to July 2007, the optimists had the upper hand, and the Dow topped 14,000. This, even though the rapidly ballooning pool of adjustable rate, no doc, no income, no job, no assets, head-in-the-sand mortgage loans was well-known to Wall Street and the real estate industry. Then, in late July, the accumulated evidence of financial rot suddenly precipitated a market retreat. Since then, the pessimists have held sway.

But the optimists remained, waiting on the sunny side of the Street for an excuse to buy. And the Fed's discount rate cut gave them that excuse. Choosing to see empathy and sympathy from the central bank, they plunged back into the melee, pushing back the forces of doom and gloom 233 points.

The Fed's discount rate took advantage of the dual-sided nature of the market. It was an ambiguous step--enough to give hope to those that feed on hope, but not so generous that it looked like a bailout of the professional speculators who created the subprime mess. Friday's rally helped to stabilize things, at very little real cost to the Fed. The Fed, in effect, implemented monetary policy at a discount rate.

The ambiguity of the discount rate cut is reminiscent of Chairman Greenspan's oft indecipherable ramblings, which could be interpreted to fit your mood, whatever it might be. His ambiguity allowed listeners of all stripes and varieties to hear what they wanted to hear--so much so that market volatility fell, risk aversion went the way of the dodo, and all asset classes prospered. Unfortunately, we know how that story ended.

When Chairman Bernanke took office, he promised to provide more clarity about the Fed's intentions. All else being equal, clarity is a good idea. Yet, here he is, 18 months later, perhaps a little Greenspanian himself. Why the reversion?

Because the Fed doesn't know what the best course of action is. The unregulated nature of the derivatives market has left the Fed with a paucity of information. It doesn't know what risks and losses have come to rest where. It doesn't know, amidst the intertwined, overlapping, laid off, and offsetting thicket of derivatives exposures in today's financial markets, who's holding the hot tamales. The Fed is flying on instruments, and the instruments can't detect everything that's out there.

Ambiguity may work for a while. And if it works well enough, the markets may stabilize and asset classes unrelated to the mortgage mess may recover. But uncertainty and lack of information will continue to plague the Fed and other central banks. They may feel compelled to cut interest rates at some point. The darndest thing, though, is that they probably won't have a very clear idea whether or not their interest rate policy will work.

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