The Fed’s ‘clear message’

In announcing Friday morning its decision to lower the discount rate, the interest rate the Federal Reserve charges member commercial banks for borrowing at its discount window, the Fed has devised a creative, ingenious response to a specific problem. The Fed had spent the previous week injecting tens of billions of dollars into the overnight market to prevent the federal-funds rate from rising above the Fed’s target level of 5.25 percent. The fed-funds rate is the interest rate that banks charge each other for overnight loans.

This rate had been approaching 6 percent as banks became leery of lending to each other; nobody knew the others’ exposure to subprime and other increasingly suspect securities. Despite the huge injections of dollars by the Fed and other central banks, the financial markets remained on the boil.

When the Fed announced on Aug. 10 that it intended to provide the necessary dollars to enforce the fed-funds rate of 5.25 percent, it pointedly noted that, “[a]s always, the discount window is available as a source of funding.” However, banks historically have been reluctant to borrow at the discount window, whose interest rate is higher than the fed-funds rate, because it might be taken as weakness. The Fed has tried to dispel that fear in several ways. When the Fed lowered the discount rate by half a point to 5.75 percent on Friday, it also increased the loan period from a single day to “as long as 30 days, renewable by the borrower.” Not only is the Fed discount window available “as always,” the central bank effectively said, but to encourage its use, the Fed offered much better terms to prospective borrowers. The Fed further emphasized that it would “continue to accept a broad range of collateral for discount window loans, including home mortgages.” A Fed-initiated conference call later made clear that borrowing from the Fed’s discount window would be considered a sign of strength, not weakness.

While investment banks and hedge funds cannot directly borrow from the Fed, they can take their unimpaired mortgage-backed securities to commercial banks as collateral for loans. Those commercial banks can then pledge those securities as collateral at the Fed’s discount window. The Fed “really wanted to drive home the point that if [bankers] were complaining about not being able to borrow money against liquid, high-quality securities — mortgages — [then] we [now] have no more basis for complaint,” a banker who participated in the Fed’s conference call told the Wall Street Journal. “We were all given a clear message.”

Thus, the Fed has creatively aimed its resources at a specific liquidity problem without worsening the problem of moral hazard, which could occur if the fed-funds rate were cut.