Friday, August 17, 2007

More on the Discount Rate

Earlier today, I wrote a commentary on the change in the Discount Rate in which I said I did not believe the change would matter very much.

I should clarify.

I do not believe that the cut will matter much in regard to the systemic problems we're seeing with structured products and risk aversion.

I do believe, however, that it was a masterful stroke.

The Federal Reserve is in a difficult position. If they cut interest rates, the dollar would likely drop, and inflation (which, even at current rates, is extremely difficult to maintain within the Fed's specified bands) would likely rise to unacceptable levels.

By lowering the Discount Rate, and easing some of the terms for borrowing from the District Banks, the Fed has, quite literally, stopped a run on the bank (Countrywide, in particular). I mentioned this in the earlier post, but I feel that I did not give the Fed enough credit for what they did.

Lowering the Discount Rate (which is still priced above the Fed Funds target) gives banks that have been experiencing larger than normal withdrawals, and limited availability of funds due to risk aversion (fear), to support both those withdrawals and their mandated capital requirements. The fear in this case, of course, is a fear of bank failures primarily related to the expected continuation and expansion of mortgage defaults).

Doing this, however, does not have the same effect that a cut in the Fed Funds target would have on overall short term rates. So no unusual inflation, etc.

In the near future, I will address why I do not believe that the Fed, or the Federal and State Governments, can do much to alleviate the situation without exposing tax payers to an expensive bail-out plan. A bail-out would be popular with some, but the actual cost, and the need for greater tax revenues, would create an extremely unpopular situation.

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1 comment:

Anonymous said...

Good article Lawrence!