December 13, 2007
Counting the instruments
If you are following monetary policy in these testing times, and especially if you find recent Fed actions (and the markets’ reaction to them) puzzling, two posts by James Hamilton at Econbrowser will help. Not that they clear things up, so much. But they make being puzzled an easier position to defend. First, James ponders the "surprise" cut of only 25 basis point in the fed funds rate.
Was Wall Street really expecting a 50-basis-point cut? Looking at fed funds futures or options, you might have thought this was a significant possibility. For example, the graph below is the interest rate implied by the January fed funds futures contract, which historically has proven to be an excellent predictor of the monthly average fed funds rate. This had been trading at 4.18% prior to the meeting. Since the FOMC is not scheduled to meet again until January 29/30, one might have read this as implying a 30% chance of having seen a 50-basis-point cut from yesterday’s meeting:
(0.7)(4.25) + (0.3)(4.0) = 4.18
Implied interest rate on January 30-day fed funds futures contract. Data source: TFC.
But here’s the curious thing: as of this writing, the price of that contract still has not budged more than half a basis point from where it stood at the close of trading last Friday. Fed funds futures traders seem not to have been surprised in the least by the outcome of Tuesday’s meeting.
So why did the market drop? "Beats me," he concludes. James next looks at the Fed’s new "term auction facility":
Evidently there are those who entertain the hope that the Fed could find two separate tools to achieve two separate ends. The first tool– the traditional instrument of monetary policy– is to adjust the total quantity of reserves available to the banking system so as to achieve a particular target value for the fed funds rate, the rate at which one bank lends to another overnight. When one describes a traditional monetary policy action as "providing liquidity," this is what we are discussing.
But there appears to be a widespread belief that the Fed needs a second tool in order to achieve a second policy objective, which is somehow to eliminate the gridlock in financial institutions resulting from huge holdings of assets that no one seems willing to buy. Perhaps, the thinking seems to go, adjusting the spread between the discount rate and the fed funds rate could be a tool to accomplish this.
I am inferring that the Fed itself may also have been musing along these lines, in that it today announced creation of a term auction facility. The basic idea is that the Fed will specify a certain maximum amount that it would like banks to borrow. It intends to lend up to $20 billion for a 28-day term on Monday, and lend up to an additional $20 billion for a 35-day period on December 20. Potential borrowers will bid an interest rate to receive this loan, with I presume each $20 billion going to the highest bidders. Banks must also provide collateral for these loans.
The objective is clearly not just to get $40 billion more in reserves into the banking system next week– an open market operation could accomplish that just fine. The objective must be to get the reserves into the hands of those particular banks that want them most…
The other thing the facility accomplishes is allow the Fed to accept lower-quality collateral from borrowers than its rules require for open market operations conducted through repurchase agreements. If there is an effect of the facility, I would think that this would be the mechanism. What may matter is not the reserves put in the system, nor who gets those reserves, but the troublesome assets temporarily taken off some institutions’ balance sheets.
Isn’t that a "bail-out"?
The Fed’s initiative was announced in concert with other big central banks, which also took steps to boost liquidity. As the FT reported, however, short-term interest rates hardly budged. The markets don’t yet know what to make of it all.
Clive, the bail-out word has used by a number of blogs. I think it is a bit short-sighted to scream bail-out when the Fed is taking a nuanced approach to the problems in the credit markets.
Basically the Fed is trying to address the distribution issue when it is carrying out its role of ensuring financial stability. Obviously the open market operations tool was not designed for episodes like the current one where trust between market participants has collapsed and banks just want to conserve resources. The Discount window faces the long standing problem of stigma. To circumvent this problem the Fed has, according to me, hit upon a brilliant solution to enable banks to borrow directly from it at a rate that will, I think, settle in the corridor between the fed funds rate and the discount rate.
Ultimately this whole credit crunch may not just be a liquidity problem but a solvency problem. If that is the case, some banks will take the hit and pay the dues. I don’t think it is the Fed’s intention is to ensure that banks’ solvency problems are sorted out. It is just to buy time and keep the money markets functional while the financial markets sort out the good from the bad.
Wall street would prefer Fed to just cut the fed funds rates by a hefty chunk and get it over with. Under Greenspan, Fed would have responded in this fashion. The Bernake Fed is more worried about inflation, which is how central banks should be,and is more collegial to boot. It is also uncertain about the future and is conveying that uncertainty (for example the last para in the FOMC statement). So Bernanke will not give in to markets and will cut Fed funds rate only gradually and that too only on further evidence.
Will the Fed’s new term facility work? Who knows? Even the Fed doesn’t know yet. But it is worth a try. I would give the Fed full marks for trying something innovative.
Posted by: athreya | December 14th, 2007 at 9:47 am | Report this comment