Friday, December 14, 2007

The Fed's TAF Reveals Credit Crunch Policy Conflict

The Federal Reserve’s newly announced Term Auction Facility (or TAF) reveals a conflict between the Fed’s goals of spurring economic growth and easing the credit crunch.

The Fed’s reductions of the fed funds rate, done to stimulate economic activity, may have the perverse effect of making interbank loans scarcer. The fed funds rate is the interest rate for overnight loans between banks. The credit crunch has manifested itself most acutely in the reluctance of major banks to lend to each other, for fear of undisclosed mortgage and related losses. That, in turn, has constrained lending by banks to others. By lowering the fed funds rate, the Fed reduced the remuneration banks receive for taking the now heightened risks of lending to each other. Let’s return to Econ 101 for a moment. If you want more supply, using a government price control to reduce prices isn’t exactly the most effective way to go. Lenders want more compensation for lending to banks, not less.

There is some evidence that the lower fed funds rate conflicts with market perceptions of the creditworthiness of banks. LIBOR, the interest rate charged in dollar-denominated interbank loans in the overseas financial markets, has remained stubbornly high around 5% in spite of the Fed’s cuts of the fed funds rate to 4.25%. LIBOR is a market rate, set in London without any Fed oversight. It would appear to indicate that people in the business of making loans judge banks to be lousier credits than would be justified by the fed funds rate.

The TAF purports to address the problem with 28-day government loans to banks at rates expected to be lower than LIBOR. The TAF will auction loans to be made through the Fed’s discount window. In general, banks prefer not to borrow from the discount window, which they have regarded as indicating weakness and therefore a last resort. The Fed has been steadily reducing the discount rate charged for loans made from its discount window, and has stated that it will not regard borrowing from the discount window as a sign of weakness. That, however, has done little to change the reluctance of banks to borrow from their regulators. It remains to be seen whether they will view TAF loans, even at bargain rates. any differently.

The credit crunch is driven by lack of information and uncertainty. Investors and lenders don’t know how bad the banks’ mortgage and related losses are, and are understandably reluctant to invest in or lend to them. Lowering the fed funds rate and providing a government subsidy through TAF won’t do a lot to resolve these problems. Requiring banks to disclose exposures, write down losses and bolster their capital would clear the air. That would hurt, but the ongoing credit crunch isn’t exactly painless. Given the magnitude of the mortgage and other losses we’re dealing with, there isn’t a way to avoid major pain. The only question is what is the sensible way to deal with the pain.

Holiday News: decorations for the Garden State Parkway.

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