Getting Liquidity to the Choke Points

Recently, in a post titled Can Policymakers Keep Credit Markets from Freezing Up?, I said:

Getting liquidity to the choke points, many of which are outside the traditional banking system, is a tough problem for the Fed to solve since most of its tools operate within the traditional banking system. It has been creative, e.g. changing collateral rules so that banks could act as intermediaries between mortgage lenders and the discount window, but there are limits to what it can do within the existing regulatory structure.

The Fed has now taken another creative, and likely useful step in getting liquidity to the "choke points" outside the traditional banking system:

Fed Joins Other Banks in Measures To Inject More Funds Into Markets, by Greg IP, WSJ: The Federal Reserve has joined with four other major central banks to announce a series of measures designed to inject added cash into global money markets in hopes of thawing a credit freeze that threatens their economies.

The Fed said today it would create a new "term auction facility" under which it would lend at least $40 billion and potentially far more, in four separate auctions starting this week. The loans would be at rates far below the rate charged on direct loans from the Fed to banks from its so-called "discount window." But the new loans can still be secured by the same, broad variety of collateral available that banks pledge for discount window loans.

The European Central Bank, Bank of England, Bank of Canada and Swiss National Bank simultaneously announced parallel measures. "This is not about particular financial institutions with particular problems. It is about market functioning," said a senior Federal Reserve official...

The Fed also said it had created reciprocal "swap" lines with the European Central Bank, for $20 billion, and the Swiss National Bank, for $4 billion. These will enable the ECB and SNB to make dollar loans to banks in their jurisdiction, in hopes of putting downward pressure on interbank dollar rates in the offshore markets, principally the London Interbank Offered Rate, or Libor, market. The inability of foreign central banks to inject funds in anything other than their own currency has been a factor creating the squeeze on bank funding in those markets.

The Fed has worried that banks' growing reluctance to lend either to other financial institutions or to businesses and consumers could cause the flow of credit to dry up and drag the weak economy into recession. ...

The new loans will be auctioned off with a minimum rate linked to the expected actual federal funds rate over the duration of the loan. Since the federal funds rate is expected to decline over the next two months, when the loans will be outstanding, the loan rate could end up being close to or even below the current federal funds rate. ...

The Fed indicated that the new facility could become a permanent addition to its monetary policy toolkit. ...

It remains unclear whether the new operation will do the trick. But the early reaction was favorable: Treasury bond prices plunged and their yields shot up in early trading, a sign that investors are abandoning the relative safety of Treasurys and preparing to bid up riskier debt. Futures markets suggested stocks would rise at the opening.

I'm sure we'll hear the usual bailout and moral hazard objections, but this sounds like a good idea to me. Think of it this way, if the economy does go into a recession, it will be far more costly than the 40 billion the Fed plans to loan financial firms, and the costs will not be limited to those who bear responsibility for the problems, they will be widely felt. Thus, if this works, it will be money well spent.

Update: Steve Waldman at Interfluidity with his first reactions to the plan. [Apologies to Steve for the confusion on the name which has since been corrected.]