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Federal Reserve Cuts Discount Rate to Steady Market

Acknowledging a period of increased economic risk that could restrain growth, the Federal Reserve on Friday cut the discount rate at which it makes loans to banks. An economic consultant and a business journalist explain the move.

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    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.