The Fed Panics and Cuts Rates

The Fed Panics and Cuts Rates





Posted on Aug 17th, 2007

Michael Panzner submits:
Although the initial reaction is one of euphoria, today's surprise
discount rate cut by the Federal Reserve may have unintended
consequences. In fact, it will likely be the trigger for the next leg down in the unfolding bear market.
For
one thing, the move suggests that policymakers are worried - really
worried - about the state of the economy, despite repeated assertions
to the contrary. That is likely to force a rethink by nervous bulls in
corporate America and elsewhere who have reluctantly accepted the party
line that all is well.
The abrupt shift in stance, following
meeting after meeting where policymakers expressed concerns over the
pace of inflation, may also signal that thinking has become muddled at
the Fed. Or that monetary policy is now in the hands of investment
bankers and hedge funds. Some might even start wondering whether
Bernanke & Co. have lost their way, at least in the near term. Not
exactly a reason for optimism at a time when credit markets are under
siege and risk is being dramatically repriced.
Clearly, the
bears were caught off guard by the surprise cut. However, while a burst
of short-covering and speculative buying can heighten the drama and
paint a picture of benevolent central bankers riding to the rescue, it
will also add to confusion about where policymakers stand. What
happened to the new, more transparent Fed? Worse still, is this a sign
that we returning to the bad old bubble-blowing days of the Greenspan
era?
Finally, although equity markets have been under a great
deal of pressure lately, the S&P 500 index is still basically up on
the year. What’s more, the latest reading on gross domestic product
signaled to many that U.S. growth remained on track. The big risk in
shooting off a round of monetary bullets this early in the game is that
the effect doesn’t last very long. In that case, the mood is likely to
be even uglier during the next round of liquidation and de-leveraging.
All
in all, today’s move, while positive for sentiment in the short run, is
unlikely to represent anything more than a temporary shot of adrenalin
for wounded markets. Once the injection wears off, the bearish disease
will likely be back in force.

Daily Global Commentary






Fed Lowers Discount Rate and Changes Policy Bias



Sat, Aug 18 2007, 07:14 GMT
by Asha BangaloreNorthern Trust

In
a surprise move this morning, the Fed announced a 50 bps cut in the
discount rate to 5.75% from 6.25%. The target federal funds rate was
left unchanged at 5.25%. The Fed typically implements monetary policy
by changing the federal funds rate. This unconventional action is due
to extraordinary circumstances.Before we comment on the
motivation for the new procedure, here is a brief background about the
current Discount Window Lending Program. “The Discount Window functions
as a safety valve in relieving pressures in reserve markets; extensions
of credit can help relieve liquidity strains in a depository
institution and in the banking system as a whole. The Window also helps
ensure the basic stability of the payment system more generally by
supplying liquidity during times of systemic stress”. Funds are made
available through four different programs: (1) Primary Credit, (2)
Secondary Credit, (3) Seasonal Credit and (4) Emergency Credit.
Additional details about the program can be obtained the Fed’s website
(Discount Window Lending Program). The new 5.75% rate is applicable to
borrowing from the Discount Window under the primary credit program.
The primary credit program is the “principal safety valve” through
which Fed ensures adequate liquidity in the banking system and it is a
backup system for short-term funds for “generally sound depository
institutions.” There are no questions asked about the reason for
borrowing and there is no cap on the amount of funds that are available
under this program.Why did the Fed change the discount rate and
not the federal funds rate? Discount rates are established by each
Reserve Bank's board of directors, subject to the review and
determination of the Board of Governors of the Federal Reserve System.
Today’s change in the discount rate was an official request from the
Federal Reserve Banks of New York and San Francisco. There is no
special significance to the fact that it was requested by only two
banks. In addition to lowering the discount rate, the Fed modified the
term of the loan. The Reserve Banks’ usual practice is to make funds
available overnight through the primary credit program. Today’s
announcement noted that financing is available for long as 30 days and
it is renewable by the borrower. The Fed also increased the range of
assets that will be acceptable as collateral under this arrangement
compared with that of open market operations. These provisions indicate
that the Fed strongly believes that addressing the problem of liquidity
is the top most priority. The Fed has chosen this route given the
difficulty in estimating what banks’ demand for excess reserves are on
a regular basis. As chart 1 shows, the Fed has erred on the side of
supplying too many reserves rather than too few, with the daily
effective federal funds rate trading below the FOMC’s target of 5-1/4%
in the past several days. In sum, this innovative procedure under
exceptional circumstances has given the Fed flexibility and bought time
to evaluate the situation.In addition to the discount rate
announcement, the Federal Open Market Committee (FOMC) also made a
formal statement. The FOMC, which makes decisions about the federal
funds rate, left it unchanged at 5.25%. The statement noted that
“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.” Although the statement was not phrased explicitly to indicate
a change in policy bias, effectively, the FOMC has abandoned inflation
as the predominant risk and replaced it with economic growth as the
primary concern. As recently as August 7, the Fed viewed inflation as
the major risk facing the economy.The obvious questions now are
if and when the Fed will lower the federal funds rate. The prescription
the Fed has chosen targets liquidity and credit problems. If the
prescription fails to work, the Fed will need to lower the target
federal funds rate to maintain economic growth. It is entirely
conceivable the Fed can lower the federal the funds prior to the
September 18 FOMC meeting given that it now sees an explicit risk to
economic growth. Between now and September 18, the Fed will have
reports about home sales during July, car sales, employment numbers,
ISM manufacturing survey, retail sales, consumer confidence measures
for August, and durable goods orders for July. Each of these economic
reports will give new insights about the economy but financial market
stability trumps all other considerations, for now.