Moral Hazard on Wall Street and Main StreetBy Marc Chandler
RealMoney.com Contributor8/17/2007 5:22 PM EDTClick here for more stories by Marc Chandler The
Federal Reserve has taken several
steps up a policy-escalation ladder to address the turmoil in the
capital markets. It has allowed the fed funds rate to deviate sharply
from its target and has created conditions that have allowed an
approximately fivefold increase in excess reserves of the banking
system.The Federal Reserve took additional steps earlier
today. First, it liberalized the so-called discount window borrowings,
which are neither at a discount nor take place at a window. The Fed cut
the punitive rate from 100 bps more than the fed funds target to only
50 bps and lengthened the period that the funds can be borrowed.
Yet, discount window borrowings are minor ($265 million total in
the week ending Aug. 15), and the discount rate is still above the fed
funds target and well above the recent average effective fed funds rate
(weighted by size). As such, these moves are largely symbolic. Second, and arguably more importantly, the Fed changed its
bias by saying "Financial market conditions have deteriorated, and
tighter credit conditions and increased uncertainty have potential to
restrain economic growth going forward." This was the first sentence of
their statement with the announcement of the changes in the discount
facility.
This is important because it represents a stronger recognition
of the potential for the macroeconomy to suffer from the capital-market
turmoil than was expressed in the Fed's statement after the Aug. 7 FOMC
meeting.
Over the last couple of weeks, we have argued that the bar for
a Fed cut was high and that a material impact on the real economy would
be necessary. With today's statement, the Fed, in effect, indicates
that it is a bit closer to the bar than it was previously. This means that the odds of a September rate cut have
increased. However, it is not a done deal. First, the Fed explicitly
stated that the discount moves were temporary and indicated that "these
changes will remain in place until the Federal Reserve determines that
market has improved materially."