Fed: Cuts Discount Rate

In a surprise announcement this morning the Federal Reserve Board approved a cut in the discount rate, the rate at which banks may borrow directly from the Federal Reserve, of 50 basis points to 5.75%. The Fed also announced that it was changing the standard terms of loans at the discount window to allow for borrowing up to 30 days, a significant increase from the overnight timeframe at which this lending typically occurs. In addition, borrowing at the discount window can be renewed at the option of the borrower.

In effect, the Fed is trying to make it less costly for banks that need financing to obtain it. In contrast to standard open market operations, which require that banks put up Treasury bills, agency debt, or agency pass-through securities (i.e., mortgage-backed securities guaranteed by Fannie Mae or Freddie Mac) as collateral, the discount window will accept a range of collateral, including asset-backed securities, commercial mortgage-backed securities, and mortgage-backed securities.

The Fed has viewed the financial turbulence that has rocked financial markets over the last few weeks as primarily a liquidity crisis and not as an economic crisis. It started by providing large amounts of overnight liquidity to bring the overnight interbank rate (i.e., the effective Fed funds rate) back to the target of 5.25%. The Fed next provided financing for 14 days in an attempt to bring money market rates, which have spiked up recently, back down. The reduction today in the discount rate is the latest move by the Fed to provide liquidity to parts of money markets that need it.

In our view, the probability of a rate cut ahead of the September 18 FOMC meeting has gone down. That said, the Fed also said this morning that it was “prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.” In other words, it will watch to see if its latest action brings liquidity back to credit markets. If credit markets start to operate again, the Federal Reserve may determine that a rate cut at the September 18 FOMC is not needed. However, it also said that “downside risks to growth have increased appreciably.” If the FOMC determines that the recent turbulence in financial markets will cause growth to slow further later this year and early next year, then the door will be open to a rate cut or two later this year. This is especially true if CPI inflation, which has been trending lower over the past few months, continues to come down.

Federal Reserve and FOMC Statements Today

Release Date: August 17, 2007

For immediate release

Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee 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.

Release Date: August 17, 2007

For immediate release

To promote the restoration of orderly conditions in financial markets, the Federal Reserve Board approved temporary changes to its primary credit discount window facility. The Board approved a 50 basis point reduction in the primary credit rate to 5-3/4 percent, to narrow the spread between the primary credit rate and the Federal Open Market Committee's target federal funds rate to 50 basis points. The Board is also announcing a change to the Reserve Banks' usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower. These changes will remain in place until the Federal Reserve determines that market liquidity has improved materially. These changes are designed to provide depositories with greater assurance about the cost and availability of funding. The Federal Reserve will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets. Existing collateral margins will be maintained. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York and San Francisco.

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