The Federal Reserve buckled down to market pressure this morning by lowering the discount rate from 6.25 percent to 5.75 percent. With equity markets around the world continuing to sell off (Nikkei dropped by the largest amount in 7 years), the Fed resorted to their next best option before being forced to cut the Fed Funds target rate. Along with the cut, they issued a statement that was far more dovish than the one released after the August 7 FOMC meeting which multiplies the likelihood of an actual target interest rate cut next month.
This has already led to a complete turnaround in the European stock markets, US stock market futures, and carry trades. The dollar on the other hand is being hit by the announcement as risk aversions starts to subside. If this sticks, we may have reached a near term bottom in the financial markets.
What is the Difference Between the Discount Rate and the Fed Funds Rate?
The Federal Reserve lowered the discount rate this morning and not the Fed Funds rate, which remains at 5.25 percent. The discount rate is the rate that the Fed charges to lend money directly to banks and other lending institutions. It is also the rate that Jim Cramer have been screaming for the Fed to cut. The Fed Funds rate on the other hand is the rate that banks ay to borrow from the marketplace (and not the Fed). The central bank’s move today narrowed the spread between the primary credit rate and the FOMC target rate to 50 basis points. They are also now allowing the terms of financing to extendas long as 30 days, renewable by the borrower.
Federal Reserve Alters Bias, Warns of Strong Downside Risks
In addition to the change in the discount rate, the Federal Reserve also altered their economic outlook to acknowledge the recent turmoil in the credit markets. It was only 2 days ago that Fed President Poole downplayed the impact of the market swings on the “real economy.” Interestingly enough, he did not vote in favor of the new policy announcement. The Fed now feels that the downside risks to growth have increased significantly and economic growth going forward will probably be restrained by the credit crunch. This is the intermediate step that the Fed needs to take in order to lower interest rates in September. The futures curve is now pricing in at least 75 basis points of easing in the Fed Funds rate by the end of the year. Cutting the Fed Funds rate has become the central bank’s last resort. With the discount rate cut, they have done everything but cut the Fed funds rate.
These are the Press Release from the Fed this morning (they came at the same time):
Release 1
Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.
Voting in favor of the policy announcement were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Richard W. Fisher; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Michael H. Moskow; Eric Rosengren; and Kevin M. Warsh.
Release 2
To promote the restoration of orderly conditions in financial markets, the Federal Reserve Board approved temporary changes to its primary credit discount window facility. The Board approved a 50 basis point reduction in the primary credit rate to 5-3/4 percent, to narrow the spread between the primary credit rate and the Federal Open Market Committee’s target federal funds rate to 50 basis points. The Board is also announcing a change to the Reserve Banks’ usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower. These changes will remain in place until the Federal Reserve determines that market liquidity has improved materially. These changes are designed to provide depositories with greater assurance about the cost and availability of funding. The Federal Reserve will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets. Existing collateral margins will be maintained. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York and San Francisco.
By Kathy Lien, Chief Strategist of DailyFX.com