VoxEU Column Financial Markets

While the ECB ponders, the Fed moves, and cleverly at that

The Fed move, to cut the discount rate while keeping the Fed Funds rate unchanged, is both innovative and shrewd. It allows banks to liquefy discredited mortgage assets at low cost while leaving open the decision on monetary policy. It also leaves in the Fed’s hands the more powerful tool of cutting the Fed Funds rate if its action does not succeed in quieting market fears.


The Fed has moved smartly and ahead of the crowd. While markets and analysts have debated whether the Fed – and the ECB and the Bank of Japan – should change their policy orientation, the Fed has invented a new response – lower interest rate costs while keeping the policy stance unchanged.

First, what did the Fed do? The Fed provides liquidity to the banking system mostly through its regular sales on the open market. These sales, in effect renewable very short-term loans, are designed to keep the open market rate – the so-called Fed Funds rate – at the Fed’s pre-announced target level. The Fed did not change this target level so it remains at 5.25% -- just where it has been for more than a year. The Fed Funds rate, however, is not the only game in town. While the open market is where normally banks and other eligible financial institutions go to find the cash they need, or to download temporarily excess cash, the Fed stands ready to lend cash on an emergency basis through its ‘discount window.’  The rate at which it does this emergency lending is called the ‘discount rate.’

To make sure that the discount window is not used to by-pass the open market, the interest rate charged at the discount window is higher than the open-market Fed Funds rates – normally by a full percentage point. Also, the list of collateral assets that must be deposited with the Fed as a guarantee is more restrictive than those commonly required in the open market.

On August 17, the Fed lowered the discount rate from 6.25% to 5.75%. But it did not change its target for the Fed Funds rate; that remained at 5.25%. In essence, it made recourse to the emergency lending discount window less expensive without changing its target for what the market interest rate should be. It also announced that it would accept as collateral a wider range of assets, including the troubled mortgages, and that it would lend for longer periods, up to 30 days.

What is smart about this is that the Fed has – in one stroke – relieved pressure on the credit market without changing the Fed Funds rate and, simultaneously, kept its options open for its next decision due September 18. The Fed has had its cake and ate it too.

The thing to fear is fear itself

Whether the current crisis is a temporary hiccup or the beginning of a serious financial meltdown remains very much an open question. In my recent Vox column, I argue that the subprime crisis is perfectly digestible without wider trouble, but that panicky market reactions could well drive financial markets down worldwide. We are now in one of these delicate moments when potentially irrational market expectations drive outcomes, which then make expectations look rational ex post. Breaking this vicious circle is a necessary step in stopping the stampede. Only central banks can do this; the Fed is first in line do so.

The Fed, however, faces a delicate balancing act. It has been worried about a resurgence of inflation and this is why it has kept the fed Fund rate at 5.25% (a rather high level) for more than a year. Before the crisis picked up speed, it obviously intended to wait and see before embarking on a path of declining rate. Most observers thought that this caution made a lot of sense. If the crisis now subsides, such a stance still makes sense. This is why the Fed does not want to rush in and cut the Fed Funds target rate. On the other hand, if the crisis persists and or, deepens, the Fed can shift its concerns away from inflation and toward a possible recession. It is of the essence, then, to still wait and see.

It is also essential to do everything that is humanly possible to significantly reduce the very real possibility that the crisis deepens. By reducing the discount rate, and accepting the infamous mortgage-linked assets as collateral, the Fed is offering markets a very strong reassurance. They can now find cash, and use the hot potato as collateral, in virtually unlimited amounts, at a cost, of course, but a very moderate one. The odds of a meltdown have now decreased.

Will that be enough to bring some much needed quiescence? Only time will tell, of course. If it does not, then the Fed can reduce its interest rate, on September 18 or anytime beforehand. Herein lays another great merit in the Fed’s actions today. It has fired a powerful shot, but it kept the heavy artillery in reserve.

The ECB’s next move

Attention will now move to the ECB. The debate on whether the ECB should give up its long held plan to raise its interest rate at its September 6 meeting is swelling. Some argue that changing its mind would be a loss of face, a very silly view since the situation has radically changed, but silliness is part of life. Others call for a pause before the next step – basically a wait-and-see stance. Yet others want to see the ECB completely reverse tack and lower the interest rate to deal with the crisis. For the ECB, too, this is a catch-22 situation. An innovative reaction is required. It might be difficult to do better than follow what the Fed did today.

Central bank legend has it that governors earn – or destroy – their reputations in times of crisis. For months, Fed watchers had tried to gauge Ben Bernanke. All they had to chew upon was what he was saying and not saying, not what he was doing because there was nothing particularly challenging in his actions. The elegant solution just adopted will undoubtedly kick-start the Bernankemania that was becoming overdue and dispel the long shadow of the Maestro, his larger than life predecessor. A good omen for these troubled times.


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