Fear and Greed Blog

This morning, the Federal Reserve reduced the Discount Rate by 50 basis points. Does it matter?

In my opinion, not very much.

The Discount Rate used to be the tool that the Fed used to move interest rates up and down. Today, the Federal Reserve discourages depository institutions from borrowing at the "Discount Rate Window," and has focused its efforts on the Fed Funds Rate.

The Fed Funds market provides a means for depository institutions to lend reserve capital to each other. In exchange for lending the reserves, the lending institution receives a negotiated rate. The weighted average of these trades is the "Effective Federal Funds Rate." The Fed intervenes in this market, through "open market operations" where they either lend or borrow funds to keep the Fed Funds Rate close to their publicly announced target.

This week, the Fed was compelled to become very active in the Fed Funds market (conducting open market operations) in order to provide reserve capital to financial institutions, allowing those institutions to maintain the required levels of reserves on their balance sheets. Risk aversion had gotten to the point where banks didn't want to lend reserves at rates near the Fed's target.

By lowering the Discount Rate, the Fed has reduced the need for these open market operations.

The latest reserve report, however, shows that the level of required reserves has moderately declined, while total reserves have significantly jumped in the latest period. This may be indicating that institutions are hoarding reserves and are unwilling to lend to those banks that need to borrow at the targeted rate.

The current move is explained by the Fed as "designed to provide depositories with greater assurance about the cost and availability of funding." Although the statement that the Fed "will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets." This certainly might make it easier for some institutions (like CountryWide) to obtain the required reserves given the current environment.

The issue, however, for the larger economy, is when, and at what terms, will lenders be willing to extend credit.

This move, in my opinion, will have no effect on the mortgage/real estate crisis. It will, however, help institutions endure any "runs on the bank."