Friday, August 17, 2007

The Fed Cuts the Discount Rate by 0.5% - A Little Form Over Substance

The Fed cut the discount rate this morning by 0.5%. There seemed to be a lot of excitement about this, but it is mostly form over substance. The discount rate is the rate charged by the Fed for borrowing from the Fed, which is different from the Fed Funds rate. It is rarely used and going to the “discount window” is usually considered going to the lender of last resort. But if it makes the market happy, who am I to disagree. From Market Watch or read the real deal from the Fed:

In a move wildly applauded by financial markets on both sides of the Atlantic, the Federal Reserve announced Friday that it's cut the discount rate by a half percentage point to 5.75%.

The Federal Reserve Board said it was acting to "promote the restoration of orderly conditions in financial markets." The Fed also said it would allow banks to borrow unlimited funds at 5.75% for 30 days, rather than the overnight loans previously allowed at 6.25%.

By cutting the discount rate instead of the federal funds rate, the Fed signaled that it believes problems are mainly confined to the financial system, and are not yet impacting the broader economy. The cut in the discount rate provides funds to banks, but does little to change consumer and commercial interest rates, as a cut in the fed funds rate would do.

"Markets should not be calmed by this tactic," wrote Ian Shepherdson, chief U.S. economist for High Frequency Economics. "This move is not going to provide any relief to the overall economy."
In a separate statement, the policy-setting Federal Open Market Committee acknowledged the precarious state of credit markets and the economy.

The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from regional Federal Reserve lending facilities. It differs from the key federal funds rate, which is the rate at which private institutions lend to other depository institutions overnight.

"We can only speculate about this, but the decision to move the primary discount rate rather than the fed funds rate may indicate that the Fed anticipates some institutional failure as soon as today, probably not a bank, but rather an institution that has substantial bank liabilities that may not be able to clear," Shepherdson said.

The discount window has been rarely used; only an average of $87 million is borrowed on an average day, said Tony Crescenzi, chief bond market strategist for Miller Tabak & Co. There has been something of a stigma attached to using the discount window, Morgan Stanley's Greenlaw said.

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