The Fed's Dramatic Shift

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Financial Services
The Fed's Dramatic Shift
Liz Moyer, 08.17.07, 3:00 PM ET

The Federal Reserve's largely symbolic cut in the rate it charges for banks to borrow emergency funds directly signals a dramatic shift in the central bank's outlook in just 10 days time.

The central bank has gone from being "somewhat" concerned about the downside risk to growth to the view that those risks have increased "appreciably." Still, the move Friday falls short of a change in the Fed's most important metric, the Fed Funds rate, which stays at 5.25% for now.

Instead, the Fed said Friday it was cutting the so-called discount rate 50 points, to 5.75%, to "promote the restoration of orderly conditions in financial markets." The move comes on the same day options contracts are to expire and after several days of significant downdraft in the equities markets.

Options expiration on another free-fall day on Wall Street could have exacerbated losses even more, economists say. Instead, markets opened well up, soaring above 300 points before settling back. The Dow Jones industrial average was up 192 points in mid-afternoon.

In its statement, the Fed said it "is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets."

Most economists think this means the Fed will cut rates at the Federal Open Market Committee's next meeting on Sept. 18, by at least a quarter-point. Many economists said Friday they expect the Fed to continue to cut rates into next year by as much as 75 points, which would bring the Fed Funds rate down to 4.75%.

One indication is the yield on the 2-year Treasury, which is at 4.18%, more than 100 points below the Fed Funds rate. The last time the short-term Treasury was below the Fed Funds rate by that much was in December 2000 and January 2001, and before that, in October 1998. Both times, the central bank cut rates, says Moody's Investor Service chief economist John Lonski.

"The story here is how the Fed's assessment has been revised significantly," Lonski said. "They are prepared to act."

The discount rate is what the Fed charges banks that need emergency funding and can't find it available in the capital markets. The move will make it easier for banks that are having short-term cash issues to borrow the money, though using the discount window has always come with a stigma.

The Fed has said in the last week that banks should avail themselves of the discount window, reminding the markets of its "don't ask, don't tell" policy when it comes to using the window. In its statement Friday, the Fed even lengthened the amount of time banks can borrow through the window--to 30 days from 1 day--and it said it would accept a wide variety of collateral.

It is also making it easier to accomplish these transactions by narrowing the penalty (or difference) for borrowing at the higher discount rate vs. the Fed Funds rate. Usually, the two rates move in lock-step and have a margin of 100 points, a policy established in 2003. The last time the Fed moved the discount rate without moving the Fed Funds was in 1980, said David Wyss, chief economist at Standard & Poor's Corp.

The Fed "wants to guarantee that we don't get a seizing up of lending to solvent companies because people are too afraid to lend," Wyss said. "They're saying to banks, come see us."

According to data released by the Federal Reserve Board Thursday, discount window borrowing for the last week ending on Wednesday averaged $11 million a day, up from a $3 million daily average the previous week, but not far out of the range of what has been typical in the last few weeks. The last big spike was the week ending July 19, when $145 million was borrowed on average.

The Fed doesn't say which banks borrowed for what reason, so it's difficult to interpret the data, especially the apparently small size of many of these visits to the Fed's window. Economists said there might be a spike in borrowing next week after the liquidity issues work their way through the system.

The Fed does seem to be trying to signal that the problems in the subprime mortgage markets will work themselves out over time. The cut in the discount rate injected some much needed confidence in markets that have been spooked, perhaps beyond reason, by a severe tightening in the availability of credit and in trading certain types of bonds and derivatives, making it hard for many funds and companies to raise cash.

Countrywide Financial Corp. (nyse: CFC - news - people ), the biggest independent mortgage lender, sent shock waves through Wall Street Thursday after disclosing it had to borrow all of an $11.5 billion credit line to fund short-term operations, a move that brought its credit ratings dangerously close to junk status. Countrywide had to do so because it could no longer roll over its asset-backed commercial paper, basically short-term IOUs, when the market for commercial paper seized up.

The Fed says commercial paper outstanding dropped $91 billion this week.

Some note the irony of the Fed having to open its pockets to help out banks that lent too freely and, perhaps, too much in the easy-credit boom that abruptly ended this summer.

"Any parent, whose 21-year old child has left them with the fallout of a hefty insurance bill having wrecked daddy's BMW, will have every sympathy with the Fed today," says Andrew Wilkinson, senior market analyst at Interactive Brokers in Greenwich, Conn. "The rampant mortgage market over the last several years was only partly caused by the Fed's ultra-easy monetary policy. It didn't advocate strong-arm loan tactics in a raging bull market. But here we are facing a crescendo as those same loan originators ask for easy money in order to stay in business."

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