The Fed's New Tool

As this blog discussed a few days ago, the Fed has established a new monetary policy tool called the Term Auction Facility. The reason for the TAF is that the link between the federal funds rate and the risk-free rate on short term debt has been much more tenuous since August of this year. This means that the macroeconomic effects we usually expect from a decrease in the federal funds target are not propagating though the economy.

The reason for the disconnect comes from the uncertainty generated by the mortgage mess. Wanting to overhaul their balance sheets, many commercial banks and investors alike have turned to the market for Treasury securities. Banks are looking to Treasury securities because overnight loans in the federal funds market or from the discount window are not a reasonable strategy for restructuring a balance sheet. This increased demand in the Treasury market has driven up the price and driven down yield on bonds. As a result, the impact of any Fed open market operation is reduced.

Even for the healthy banks in a position to lend, the uncertainty about the solvency of any given bank results in a higher risk premium. So not only do troubled banks face a higher price for Treasury securities, but they also face a higher rate for a 90 day loan from another bank. Combine this with the stigma and strict collateral requirements of a discount loan and some banks are really in a pinch.

One thing to note - the Fed is not changing the total value of liquidity available. So the amount auctioned off will be offset by a reduction in funds in the overnight market. Any idea on how this will work? Is the Fed going to sell Treasuries?

Let me know what you think.


The Economist had a nice article about this new policy.
A Christmas package for banks

Dec 13th 2007
From The Economist print edition

This attempt to sort out the money-market mess has its uses; but don't expect too much

IF AT first you don't succeed, try co-ordinated intervention. Leading central banks have each laboured on their own to clear the log jam in the money markets—and all have failed. The spread between the cost of borrowing for governments and that for banks has widened sharply in recent weeks. That suggests investors are warier than ever of lending to the banking system. The longer this goes on, the greater the fear that banks will drag the economy down by starving it of capital.

Christmas, when markets are closed and banks are tidying their year-end balance sheets, is always a time of sparse liquidity. This year confidence is especially fragile. The last thing the world needs is for some big bank to be scrabbling for cash on New Year's Eve. Hence this week's decision by five central banks to redirect some $100 billion of funding to the banking system—and to ensure that it can be had in dollars. Markets were torn between hope that money will at last get to those that need it and fear that the plan reveals how worried the central banks really are. They are right to be anxious: this is the authorities' best shot—and it is far from certain to work.

The plan helps explain why the Federal Reserve decided to cut interest rates by a quarter of a percentage point rather than a half (as many had hoped) on December 11th. Cuts in the official rate have proved a blunt instrument in solving the money-market crisis. Despite three reductions in the Fed funds rate, banks were still paying more on December 11th to borrow money for three months than they had been in March. Worse still, in their anxiety to rescue the financial system, central banks were endangering their anti-inflationary credentials. Headline inflation rates have stayed stubbornly elevated. The Fed reasoned—rightly—that money-market intervention was a more targeted remedy than a big rate cut would have been.

Nobody should doubt how urgently needed that remedy is. Banks have no problem borrowing money overnight, but they would be mad to rely exclusively on that as a source of funding. They need access to funding over longer periods, particularly three months. Yet those markets have been jammed as the normal providers of finance, the money-market funds, have been made skittish by losses on mortgage-related products. Central banks are trying to step into the breach.

Sick stigma

The plan is designed to deal with the things that have stymied such efforts so far. For instance, applying for help from a central bank has been seen as a sign of weakness—the financial equivalent of casting yourself as the little boy with “kick me” pinned to his shirt tail. By presenting the new package in the form of an auction, central banks hope to remove that stigma. Another disincentive for borrowers has been the penalty rates of interest charged by central banks (in particular, by the Bank of England) and the demand for very high-quality bonds as collateral. The new plan modestly relaxes such conditions.

Will that be enough? The Fed and the Bank of England have made it clear they are not adding overall liquidity to the markets (to the extent that they add money, they will take it away elsewhere). So far, the plan focuses on how to get money into the system, not how much. Yet the European Central Bank, which has been the most flexible in handling the money-market crisis, has had little more success than anyone else at reducing banks' borrowing costs. Above all, the package does not solve the fundamental reason why both investors and bankers are so reluctant to lend freely: the crippling lack of information about potential losses on subprime mortgages and related structured-debt products. Even the banks themselves will remain reluctant to lend until they know how much capital they will need to sort out the mortgage mess.

Yet the package is surely worth a try. It is worth paying a high price to stave off a liquidity crisis over new year: better that weak banks are able to borrow at the same rates as strong ones than that they are not able to borrow at all. The package will give everyone breathing space to reassess the banks' balance sheets. The hope is that a peaceful Christmas will help sentiment improve in January. But don't be fooled: it is only a hope. If it is disappointed, the clamour for central banks to start cutting interest rates will start to mount once again.