Federal Reserve Cuts Discount Rate to Steady Market
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JEFFREY BROWN: It was about an hour before U.S. markets opened today when the Federal Reserve made its move, cutting the so-called discount rate at which it makes loans to banks by half a point. The Fed put out a statement that said, in part, “Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward.”
In response, the markets surged. To help us understand today’s action and the reaction, we’re joined by Nick Perna, managing director of Perna Associates, an economic consulting firm in Ridgefield, Connecticut; and Steven Pearlstein, business columnist at the Washington Post.
Well, Steven Pearlstein, why don’t you tell us, first, what is the discount rate? And why would the Fed use it as a lever now?
STEVEN PEARLSTEIN, Business Columnist, Washington Post: Well, the Fed has basically two levers it uses to get money into the financial system. The one that we hear most often is changing the federal funds rate, which is a rate that banks lend money to each other overnight, and the Fed — they have a marketplace where they go and they set the price for that. And the Fed intervenes in that market, and it tries, by buying or selling, by offering loans or by taking loans back, they try to manipulate that price.
Today, however, they used a less frequent tool, which is the discount window. The discount window is open to banks and thrifts and a few other financial institutions that can come to the Fed and borrow money any time they want. Usually it’s overnight money. And the thing about the discount window is that it costs more than the money they might get from the federal funds overnight window, and it’s usually a percentage point higher.
The Federal Reserve today lowered that by half-a-percentage point and basically invited banks to come and use it, because there’s a stigma associated in some circles with using that. It tells people you’re in trouble. The Fed said, “Look, we understand that cash is tight, that you may need some temporary money, so here’s what we’re going to do. We’re going to lower the interest rate a half-a-percentage point. We’re going to make these — rather than overnight loans, we’re going to make them up to 30-day loans, and then you can renew them at your own request so that the money can be counted upon.”
And they basically reminded them that they would take as collateral all sorts of different securities, including mortgages. So that means people who are — banks that are holding mortgages, they can’t sell them because the mortgage market is frozen, they can at least use them as collateral to get other loans so that they can lend out and keep credit moving through the financial system.
Fed using a fine instrument
JEFFREY BROWN: So let me ask Nick Perna, what is the difference then between that and the market surging today? Is it psychological or is there a direct mechanism one leads to the other?
NICK PERNA, Perna Associates: Well, I think it's both psychological and real. The summary that was just given was perfect.
I think one of the big differences, though, is that the Fed was looking for a very fine instrument. They were preferring to use a chisel to break up the logjam and credit markets rather than a sledgehammer. And they were not yet ready to go ahead and lower the overall level of rates, which is what would have happened if they cut the Fed funds rates.
There was some turmoil in the commercial paper market very, very recently, and banks and others now will be able to bring commercial paper to the Fed's discount window, use that as the basis for getting loans, and that would sort of rejuvenate or at least put a floor under the commercial paper market.
So financial markets, the stock market in particular, felt relieved that the Fed was recognizing a problem. Secondly, markets felt that this was the Fed putting its toe in the water and that it increased the likelihood that the Fed would be cutting the Fed funds rate as the year rolled on. And so I think it's both psychological and real.
JEFFREY BROWN: And staying with you, how much of a surprise was it? Because it was only about six -- I think it was six days ago that the Fed had its regular meeting and didn't act.
NICK PERNA: Well, I think it was a big surprise, because -- exactly what you said -- the Fed's statement of a week ago was pretty tough. They said, We stand prepared to do nothing at this point, the interest rates. Our big fear is inflation.
And this time, they said -- made no mention of inflation with the statement. It's very, very unusual for the Fed to do anything between these every-six-week FOMC meetings. So that in and of itself was a big surprise. They did it very, very early before the U.S. markets opened.
I think it was a big surprise not only to everyone, but to Bill Poole, for example, of the St. Louis Fed, one of the presidents, who just yesterday said that the Fed shouldn't do anything, and he was a voting member of the FOMC. So he probably wouldn't have said anything if he thought it was in the wings.
Discussions with treasury secretary
JEFFREY BROWN: Well, Steven Pearlstein, demystify the Fed a bit more for us. When it does something like this, is it the Fed's decision alone? Are there discussions with the administration? Are there discussions with central bankers around the world? Who decides this?
STEVEN PEARLSTEIN: Well, all the above. There are a lot of discussions with the treasury, particularly between the chairman and Hank Paulson, the treasury secretary, who's a Wall Street veteran. He used to run Goldman Sachs. And Mr. Paulson basically has been spending most of the last week on the telephone with his friends in Wall Street gathering intelligence, finding out where the markets were not working, and talking to the Federal Reserve about it.
Obviously, there's the governors of the Federal Reserve, the six of them, but then there are the reserve presidents, like Bill Poole, the presidents of the regional banks. And the governors and the presidents together make up that Federal Open Market Committee. And so they were the ones that had to issue that statement.
On the question of the discount window, actually it's only the Fed governors themselves who vote on that. But there's a lot of discussions. There have been ongoing discussions all the time with the central banks around the world. And last night, the real precipitating factor here was absolute turmoil in the Japanese stock market, which went down more than 5 percent in one day.
And that was sort of the last straw. They realized they had a real global crisis on their hands, and they needed to act definitively to show that they were on the case, that they had their hand on the wheel, and that's what you got this morning. They probably decided this last night.
Bailing out high-risk investors
JEFFREY BROWN: Now, Nick Perna, you both know there has been a debate out there for weeks now about whether the Fed should step in and, in effect, whether that would be bailing out some of the very highest-risk investors, the people that took the risks and who are taking the biggest losses now. Explain that debate a little bit for us and why you think they came out where they did.
NICK PERNA: Well, I think, you know, it was easy to talk about tough love, let the chips fall where they may, when most of the damage was confined to either the subprime market or to some hedge funds and to a few high-fliers who had it coming to them, you know, if you will.
But the problem is the chips began falling elsewhere. The world was becoming more and more concerned. We were developing increasingly a credit crunch, where credit was no longer available on reasonable terms to even pretty good borrowers.
We were seeing it here at home where the market for prime loans was still pretty good, as long as those loans were under a certain size, to be specific, under $417,000. But if the mortgage was bigger than that, a jumbo mortgage, rates in recent weeks jumped through the roof. And what was happening was that people who had nothing to do with this, but whose homes were on the market, were suddenly finding that there were no longer buyers because they could no longer get mortgages at reasonable terms.
So what was happening was that there was -- the Fed today was trying to contain the collateral damage from the credit problems, the collateral damage both here at home and the United States and overseas. And the debate was over whether it should take action to protect those who made some unwise decisions. And the Fed felt that it had to overrule that and felt that the greater risk was a credit crunch and possibly U.S. and maybe even global recession.
Greasing the financial markets
JEFFREY BROWN: Now, looking forward, Steven Pearlstein, the Fed in its statement also said it was prepared -- I'll quote here -- "prepared to act as needed to mitigate the adverse effects on the economy." Now, does that suggest more to come?
STEVEN PEARLSTEIN: Well, it suggests that they're willing to, a, provide liquidity, to provide the grease for the financial system, to protect those innocent people that Nick just mentioned. But they will have to consider whether all of this credit and financial market problem is going to cause such problems for the economy that they need to do what they normally do, which is worry about a recession and, if they see it coming, lower interest rates.
Mr. Poole yesterday indicated, Look, we're not going to do anything until we see actual evidence of a downturn. And what the rest of the committee basically said was, Well, when we see the precursors of a downturn, we are going to take action. We're not going to wait to see that the GDP numbers go down or that the retail sale numbers go through the floor before we act.
And so they've probably pushed up a timetable because the economic risk has increased, not just in the United States, but around the world.
JEFFREY BROWN: Nick Perna, very briefly, do you see more to come?
NICK PERNA: Yes, I do. I see the Fed now cutting interest rates, the Fed funds rate, which is far more important, because a cut into the Fed funds rate will cut the prime rate and a lot of other rates. I see them making at least two-quarter-point, maybe three-quarter, one-quarter-point moves by the end of this year.
JEFFREY BROWN: All right, Nick Perna, Steven Pearlstein, thank you both very much.