Fed Lowers Discount Rate: What is the Effect? What Else Might They Do?
The Fed has cut the discount rate to 5.75% from its current 6.25%. It has NOT cut the Fed Funds rate, keeping it at 5.25%. The discount rate had for many years been set below the FF rate, but in January 2003 it was set above the FF rate, thus acting as a penalty rate. At that time the FF target rate was 1.25% and there were two discount rates set, a primary rate set at +100 bp to FF and another set at +150 bp to FF. That means the current discount rates are 6.25% and 6.75%. Thus the Fed has today reduced the primary discount rate by 50 bp to 5.75%.
This action and its timing has been salutary for the markets. The Fed has been providing substantial liquidity all week, enough that the effective Fed Funds rate has been at times well below the target rate of 5.25%. This makes perfect sense, since in a liquidity squeeze, the important point is to provide that liquidity and let the effective rate go where the market takes it. The action today simply reduces the penalty on discount window borrowings, and assures those banks in need of funds that the Fed stands ready not only to provide liquidity through open market operations, but will take seriously its role as lender of last resort, and will do so with less of a penalty than seen since 2003. It follows from this that should discount window borrowings increase substantially (and so far this week they have not, since the Fed has been quite generous with providing reserves), they would likely remove the penalty entirely, but it is unlikely that they would lower this discount rate to below the Fed Funds rate, as was seen before 2003. By keeping the discount rate higher than the target Fed Funds rate, the Fed encourages banks to turn to the inter-bank market first before heading to the discount window.
It is important to remember that for the most part, the action by the Fed today is largely symbolic. Not only will the separate actions to inject liquidity through daily open market operations be a much larger part of the solution, it is unlikely that discount windows borrowings will increase much through today’s action, as the rate remains a penalty rate. In addition, very few if any debt obligations are tied to the discount rate. Consumers with credit cards and home-equity loans, and even business loans, are tied primarily to the prime rate, which in turn is tied to the Fed Funds rate. By not lowering the Fed funds rate, there is very little direct economic effect to lowering the discount rate. But by lowering the discount rate and continuing to provide substantial liquidity (and not worrying where on a strictly temporary basis the effective Fed Funds rates goes by the end of the day), the Fed goes a long way to calm markets, putting markets on notice that the Fed will use whatever means is in its power to prevent panic and the kind of irrational and frenzied behavior that drove short-term rates to very low levels this week.
The Fed stated that it is prepared to “mitigate” any adverse effects on the economy, stating that market conditions may “restrain economic growth”. The Fed stated that “financial market conditions have deteriorated” and that downside risks to growth have increased “appreciably”. The Fed says that it will keep these changes until liquidity improves “appreciably”, and that they will “act as needed” to help the economy.
We should understand that “act as needed” statement to mean that additional actions might be required and the Fed will entertain all possibilities, including cutting the Fed Funds target rate. How likely is that? The market has currently priced in 100 bp in easing moves by next June. We all know that this is an imperfect measure of potential monetary policy, and should things stabilize soon, those easing moves will be priced out.
However, it is entirely possible that the Fed will ease soon, perhaps even sooner than the next FOMC meeting on September 18. Everything will depend on the Fed’s judgment of economic conditions. Should the current situation turn into more than a liquidity squeeze, the Fed should be taken at its word to “act as needed”, and cut the Fed Funds rate. It is important to note that in the statement accompanying the discount rate cut, there was no mention of the inflation bias statement present in the August 7 meeting statement. In addition, current inflation numbers, out this past week, have been benign and clear the way for the Fed to cut rates if they feel such a move is necessary. It should also be kept in mind that by cutting only the discount rate, the Fed is currently signaling both that a Fed Funds rate cut is not necessary and that they would prefer not to cut that rate now or in the immediate future. The Fed would surely love to solve this liquidity issue now, and not cut the Fed Funds rate. They stand ready to do so whenever they judge it necessary, but right now, regardless of what the Fed Funds futures market is saying, a rate cut is not a done deal.