Don't Forget about the Discount Rate

Greg Ip reminds us that the Fed also has to decide on what to do with both the federal funds rate and the discount rate at its rate setting meeting tomorrow:

Discount Rate Is Also on the Fed's Table, by Greg Ip, WSJ: When the Federal Reserve meets today, a cut in its main short-term interest-rate target, the federal-funds rate, won't be the only thing on the table. Officials will also have to decide what action to take on the lesser-known discount rate, at which banks borrow directly from the Fed.

Normally, banks pay a "penalty" to borrow from the Fed's discount window of one percentage point over the target for the federal-funds rate, at which banks lend to one another... Banks seldom borrow at the discount window because they can borrow federal funds more cheaply. The direct loans also have carried a stigma because they were often a last resort for troubled banks.

On Aug. 17, in a bid to improve the flow of cash to clogged credit markets, the Fed cut the discount rate to 5.75%, a penalty of half a percentage point above the 5.25% federal-funds target. It also extended the term of such loans to as long as 30 days from one day...

Many on Wall Street feel the Fed has yet to make the discount window attractive. The actual penalty, they note, is larger than the normal half point because the Fed has allowed the federal-funds rate to fall to 5%... Many market participants recommend that the Fed cut the discount rate so it sits just a quarter point above the fed-funds rate or even matches it.

David Greenlaw ... at Morgan Stanley, said that while he doubts the Fed is about to make such a move, it could take the place of a deeper cut in the fed-funds rate that the Fed fears could look like a bailout of investors.

Peter Hooper, chief economist at Deutsche Bank Securities, said the Fed could compromise by cutting the fed-funds rate a quarter point and the discount rate a half point. ...

Wall Street officials say they are still reluctant to borrow at the discount window because, if their identity became known, it could make counterparties skittish or hurt share prices. If the penalty were cut or eliminated, they say, banks could argue they were using the window because it was profitable. ...

Fed officials ... also worry that cutting the discount rate too much would prompt many banks to fund all of their needs from the window instead of the money market. That could make it harder for the Fed to manage the fed-funds rate with open-market operations.

It's not written in stone anywhere that there shall be a 1% spread between the discount rate and the federal funds rate. Suppose the Fed were to go back to a 1% spread, like before, and there is another financial crises. Then people will expect the Fed to lower the discount rate by .5% like it did this time and nobody will want to take out a loan until the rate is lowered (if they can possible wait). So even if the Fed does raise the discount rate to .75% or 1% above the federal funds rate, in light of recent events you have to wonder how credible a commitment to maintain the spread at .75% or 1% would be if another financial crises were to hit. For that reason, for now at least, I'd prefer to see them keep the spread as it is. If the spread is raised and things do get worse, we don't want financial institutions hesitating while they wait to see if the Fed will cut the discount rate or improve the terms on the loans in some other way. This is also a reason not to cut the spread any further. The Fed could try to argue that the circumstances are unusual enough to warrant a further cut in the spread between the federal funds rate and the discount rate, and that the action is only temporary, but from then on any trouble in financial markets would bring about speculation that the spread will be adjusted downward adding additional uncertainty at a time when that's the last thing financial markets need.

Comments

[Winslow R.]

"Fed officials ... also worry that cutting the discount rate too much would prompt many banks to fund all of their needs from the window instead of the money market. That could make it harder for the Fed to manage the fed-funds rate with open-market operations."

Don't see why this would be so. Banks would use the fed-funds rate if it fell below the discount rate keeping both at the same level. If anyone is really concerned about the Fed funds rate falling, just have the Fed offer to pay the current Fed funds rate for overnight deposits.

For it is still possible to change the equilibrium short-term nominal interest
rate by changing the interest paid on reserves.

http://www.worldbank.org/research/interest/confs/upcoming/papersjuly11/woodford.pdf

The only reason I see to not allow this is to keep the Bank of New York as the 'conduit' for reserves rather than the Fed. This move would be in the 'proper' direction as it would be a step forward to breaking the grip of the Bank of New York as the country's oldest monopoly.

http://en.wikipedia.org/wiki/Bank_of_New_York

[jan perlwitz]

Why is it so important anyway what the Fed fund rate and the discount rate are? Does it really matter whether the Fed fund rate is 4.75% or 5.25%? Why is almost everyone acting like the fate of the whole US economy or even of the world economy depends on this? Please could anyone explain to me what the causal relationship is supposed to be between the target interest rate for the overnight lending of excess reserves between banks, which are miniscule compared to the size of the whole credit market or economy, and inflation or economic growth? The whole debate about this issue looks extremely irrational to me. I just don't get it.

Thanks.

[Winslow R.]

"Please could anyone explain to me what the causal relationship is supposed to be between the target interest rate for the overnight lending of excess reserves between banks, which are miniscule compared to the size of the whole credit market or economy, and inflation or economic growth? "

You have to realize the sytem is levered with reserves at the base of the system. If the quantity of reserves collapse everything above them collapse.

The difference between the current 'natural' rate of interest an economy can sustain and the fed fund rate has a large impact on the profitability of a highly leveraged financial sector.

[jan perlwitz]

@Winslow R:

"You have to realize the sytem is levered with reserves at the base of the system. If the quantity of reserves collapse everything above them collapse."

The Federal fund reserves at US banks amount to $45 billion US-dollar only, of which only the excess reserves, about $2 billion US-dollars are lent between banks in overnight lending to maintain liquidity. This overnight lending is the target of the Fed fund rate. A collapse of the overnight lending certainly would have serious consequences for the economy, because it would paralyze banks. I think that's what you are talking about. But even a lower Fed fund target rate doesn't mean the banks won't charge higher interest rates to each other as we have seen with respect to the discount rate in recent weeks.

However, the whole discussion isn't about a necessity of a Fed fund rate cute or a discount rate cut to maintain liquidity for the banks, it's about something totally different. It is about the issue that the Fed fund rate for the overnight lending of a miniscule amount of $2 billion US-dollars between banks allegedly determines future inflation and economic growth of a 13.7 trillion economy with a credit market of a size of trillions of US-dollar. I doubt that there is any proof for this alleged causal relationship between Fed fund rate and inflation or economic growth which is apparently assumed by almost everyone to exist.

[Winslow R.]

"The Federal fund reserves at US banks amount to $45 billion US-dollar only, of which only the excess reserves, about $2 billion US-dollars are lent between banks in overnight lending to maintain liquidity."

This statement makes no sense to me. The amount of interbank loans is way over $2 billion. Where did you come up with this number? I think you are refering to how much the banks borrow from the Fed each night.

"It is about the issue that the Fed fund rate for the overnight lending of a miniscule amount of $2 billion US-dollars between banks allegedly determines future inflation and economic growth of a 13.7 trillion economy with a credit market of a size of trillions of US-dollar."

Hard to figure where to start.... Only a small portion of those 13.7 trillion dollars can be used to pay taxes. Only Fed issued reserves qualify and are a small fraction of the total.

If all the reserves were pulled from the system, everyone goes bankrupt on tax day unless Uncle Sam started accepting the ~13.7 trillion in Ford, BofA, Walmart etc. 'gift cards' as payment. Not likely to happen.

[jan perlwitz]

"This statement makes no sense to me. The amount of interbank loans is way over $2 billion. Where did you come up with this number? I think you are refering to how much the banks borrow from the Fed each night."

I have got the number from the Fed.

Non-Borrowed reserves of depository institutions:
http://research.stlouisfed.org/fred2/series/BOGNONBR?cid=123

Excess reserves of depository institutions:
http://research.stlouisfed.org/fred2/series/EXCRESNS?cid=123

The Fed fund rate is the target interest rate for which depository institutions borrow excess reserves from each other. As you can see from the graphic the total amount of excess reserves is only approximately 2 billion US-dollar, currently, despite an occasional spike.

I suppose you are mistaken, if you think that the amount is way higher.

And now, the 2 billion dollar question is, how the interest rate of this miniscule amount of money moved between depository institutions to satisfy their liquidity needs is supposed to cause higher or lower inflation in the economy or is supposed to determine the rate of economic growth.

I suspect, a reason for the general believe in this alleged causal relationship is wishful thinking that capitalist economy, the cycles of booms and busts, or inflation can be controlled by someone in charge by tuning a magical parameter.

[Winslow R.]

'Nonborrowed' is how much cash banks are holding. 'Excess' is cash beyond what is needed to meet reserve requirements. These are not interbank loans nor even loans from the Fed.

You need to reread what I wrote. Three banks could take a single dollar in reserves and loan it in a circle creating a trillion dollars in interbank loans as long as they meet capital requirements.

[Farrar Richardson]

Jan -

Three thoughts on why the Fed funds market may be more important than it looks. I don't follow this market so I'm just speculating in the hope that someone more knowledgable can set us straight.

1. Your excess reserves figure is probably a net figure, meaning the total of banks long on reserves should be considerably higher. The net, however, should be a good indicator of how tight the market is.

2. There are probably a lot of bank loan agreements which ped interest rates to the Fed Funds target (although many peg to LIBOR), so a change affects a much wider market.

3. Essentially the Fed is saying they are willing to buy (through repos) an unlimited amount of Tbills at a given price if necessary to keep Fed Funds down to a certain rate. The Fed is therefore fixing a ceiling on the cost of loanable funds for sound banks.

[jan perlwitz]

Winslow R. wrote:

"'Nonborrowed' is how much cash banks are holding. 'Excess' is cash beyond what is needed to meet reserve requirements. These are not interbank loans nor even loans from the Fed."

No, certainly not. Who said this? We are talking about Fed funds, not about interbank loans generally. The Fed fund rate is the interest rate which depository institutions charge each other, when they lend some of their excess reserves of Fed funds to each other. The Fed determines the target value for the Fed fund rate. The Fed fund rate concerns lending between depository institutions from this money pool of about $2 billion US-dollars only.

As for the total size of loans depository institutions get from the Fed. They are equally miniscule compared to the total size of the credit markets:

http://research.stlouisfed.org/fred2/series/TOTBORR?cid=122

"You need to reread what I wrote. Three banks could take a single dollar in reserves and loan it in a circle creating a trillion dollars in interbank loans as long as they meet capital requirements."

Yes, they could. There even haven't been any reserve requirements for such doing of banks since the early 90's anymore. But the interest rates for such loans, which mean money creation by banks, aren't determined by Fed's target rate. There isn't any plausibility why the interest rates of a trillions dollar credit market should be determined by the interest rate for the interbank lending of Fed funds, a miniscule money pool of about $2 billion US-dollars.

As for your recommendation to reread your previous posting. There, you wrote what would happen, if all reserves were pulled from the system.

I just didn't know with whom you were arguing at this point. I didn't say anywhere that the Fed and it's reserves didn't have any economic function at all. But what you wrote didn't shed any light on what I was asking. What the causal relationship is supposed to be between the interest rate for the lending of $2 billion US-dollar Fed funds between banks and inflation, economic growth, or the business cycle. How is the Fed fund rate supposed to influence the height of future inflation substantially, or the outcome whether there will be a recession or not? Is there any scientific proof for such a causality or is this just believe in magics?

In contrast to the Fed fund rate, government's fiscal policy probably really affects future inflation. For instance, if trillions of US-dollars are spent for armament and war, it will cause substantial inflation, since these are wasted resources from an economic point of view. These resources are destroyed, instead of being used for productive consumtion.