Friday, February 19, 2010

Getting Back to Business at the Fed

The Federal Reserve, of course, garnered a lot of press headlines today because of the announcement made yesterday that it is raising the discount rate on primary credit from 50 basis points to 75 basis points. This action will become effective today.

Note that this change came at the request of the boards of directors of the 12 Federal Reserve Banks who petition the Board of Governors for a change in this discount rate. Technically, at least, the borrowers of primary credit from the Federal Reserve System still borrow from each district bank which has its own discount rate. Thus, for a district bank to change the rate it charges on loans at its discount window, it must petition the Board of Governors. This is the archaic structure still present in the rules of the Federal Reserve for the conduct of business at the discount window in each district bank.

In addition, the Fed reduced the “typical maximum maturity f,or primary credit loans” to overnight. Earlier, as announced on November 17, 2009 and implemented on January 14, 2010, the Fed had moved to “normalize” the terms on primary credit by reducing the typical maximum maturity to 28 days.

The Fed in trying to get back to business as it was before the financial crisis. This is a part of the Fed’s “undoing.” See my Federal Reserve Exit Watch,, and my Fed “undoing” post,

The basic function of the discount window in normal times is to serve as an “escape valve” for commercial banks that need “temporary” funds to cover an unexpected need. The discount rate usually costs more than other sources of funds and borrowing is discouraged by the amount of time a bank can borrow from the Fed. But, that is the whole purpose of the “window”: it is a “last resort” for banks to relieve short run pressures on their balance sheets.

In times of crisis, the discount window is, in a sense, “thrown open” to provide liquidity to the market and overcome short term liquidity crises. A classic example of such a situation was the August 1987 liquidity crisis faced by a newly appointed Fed Chairman Alan Greenspan.

Of course, the 2007-2009 financial crises required something more and the opening of the discount window was on much more liberal terms in order to prevent the crisis from worsening.

Now, “The increase in the spread and reduction in maximum maturity will encourage depository institutions to rely on private funding markets for short-term credit and to use the Federal Reserve’s primary credit facility only as a backup source of funds.”

The Fed is trying to get back to “business as usual”. As described in the two posts mentioned above, the Fed seems to be separating its balance sheet into two parts: a balance sheet of a “traditional” central bank and a balance sheet composed of the short-term tools that were used to meet the special needs of commercial banks and the financial markets during the time of crisis.

So, these changes “are intended as a further normalization of the Federal Reserve’s lending facilities.” They are just an integral part of the Fed’s “undoing.”

In terms of the special tools, one part of the Fed’s crisis response was the implementation of the Term Auction Facility (TAF) on December 12, 2007. The Fed announced yesterday that the final TAF auction will be on March 8, 2010. This facility played an especially important role in providing liquidity to commercial banks during the financial crisis. It was seen as getting reserves to the banks that needed them more quickly than “normal” open market operations could. Furthermore, the funds were provided on a “term” basis. The Fed began to reduce the size of the auctions on June 25, 2009 and has continued to allow this line item to phase out as the year progressed. This “phasing out” is occurring with respect to other “special tools” as well.

We will continue to see more of these adjustments as the spring and summer of 2010 pass by. Market participants should not be “shocked” by these changes. They are a part of the attempt to return to a “more normal” basis for operations.

In my mind, eyes need to be focused more on what the Federal Reserve does with its securities portfolio, whether or not it is engaging in reverse repurchase agreements, and what it does to the pricing of the excess reserves the banks have on deposit at the Federal Reserve banks.

My guess is that movements will be made in these items before we see changes taking place in target interest rates. Acting in this way is more consistent with the past operations where the Fed has encouraged market conditions to change and then moved rates in line with the changes that already exist within the market. Historically, the Fed has preferred incremental moves to “market shocks”.

With market sensitivities being so “on edge” and so potentially volatile and with the “undoing” being such a massive job, the Fed cannot afford to have market emotions swing to extremes all the time. This would only make the Fed’s job that much harder.

Expect the Federal Reserve to be more subtle than that. The leaders at the Fed have a monumental task in front of them. I am sure that they hope that their “undoing” will not prove to be the undoing of all that has been accomplished up to this point in time.

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