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.