More Socialism For Banks & Hedge Funds - Fed Rewards Them For Taking Too Much Risk

Monetary policy
The first cut is the deepest
Aug 17th 2007
From Economist.com
http://www.economist.com/displaystory.cfm?story_id=9673128

The Fed reduces its discount rate and hints at a change in its policy rate too

AFP/AP

DOES an interest-rate cut always imply looser monetary policy? That was the question economists were pondering after the Federal Reserve cut its discount rate from 6.25% to 5.75% on Friday August 17th. This is the price at which banks can borrow reserves from the Fed in a pinch. But the central bank kept its main policy instrument—the Fed funds target rate, which sets the price at which banks can borrow overnight from each other—at 5.25%. The cut came after requests from two of the Fed’s regional banks in New York and San Francisco and was the latest attempt by the central bank to lubricate the banking system to prevent it seizing up.

The Fed also announced that, in a departure from its usual practice, it would provide discount lending for up to 30 days. This was a tacit acknowledgement that recent money-market interventions had failed to cap the unusually high rates banks were charging each other for one-month and three-month loans. By extending the terms of emergency lending, the Fed sought to reassure banks that the supply of dollars was not about to dry up.

 
It was not the only salve on offer. A separate statement from the Fed’s Open Market Committee hinted that policy rates might be on their way down soon as well. Turmoil in financial markets and tighter credit conditions could hurt the economy, it said, and the Fed was “prepared to act as needed” to prevent this. Bruce Kasman, chief economist at JPMorgan, said he now expects the Fed to cut its policy rate from 5.25% to 5% at its next scheduled meeting on September 18th with a further reduction likely on October 31st.

Does the cut in the discount rate mean the Fed has already loosened policy? Lending at the discount window is supposed to be penal to discourage its use. The charge is usually a full percentage point higher than the policy rate. In normal circumstances a bank would be loth to use the discount facility as, by doing so, it reveals that it cannot find funding at a reasonable price from peers—a hint of possible insolvency.

These are not normal times, however. A climate of suspicion in the interbank lending market has driven up interest rates. The creeping way in which losses in the subprime mortgage market have emerged had made banks wary of extending credit to each other. Big cash injections by central banks had helped offset the worst effects of this cash hoarding, bringing overnight lending rates down toward policy targets. But securing funds for longer periods is still difficult and pricey. Three-month interbank rates were more than 1.4 percentage points higher than government bills of the same maturity this week. The spread, which reflects the perceived risk of lending to banks, is usually around half a percentage point.

The charitable conclusion is that the Fed’s actions were necessary to open another channel of liquidity to the money markets, which were not functioning because of fear and mistrust. The discount facility bypasses the money markets and allows a far wider range of depository institutions to borrow cash directly from the Fed, with a broader range of assets as collateral. Reducing the penalty rate does not alter the overall stance of monetary policy. And the changes are temporary. The Fed says they will remain in place until it judges that market liquidity has “improved materially”.

The less charitable interpretation is that the central bank has softened the penalty for banks that have funded purchases of very illiquid assets with short-term paper. If it loosens policy while markets are only in the early stages of adjusting and before the economic risks are real, it will seem like a reward for banks and hedge funds that took on too much risk.
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