Bernanke Cuts Discount Window

A: The Federal reserve cut the discount window rate, the rate that banks can borrow at, by 50 basis points in an effort to normalize liquidity concerns amid growing downside risk to the US economy. This is an amazing move by the fed WITHOUT cutting the fed funds target rate which continues to stand at 5.25%. Bernanke is quickly gaining an enormous amount of credibility by the timing of his actions in dealing with this credit mess, and not cutting the target rate to maintain longer term policy goals. Amazing job Mr. Bernanke! First the liquidity injections and now the cur in the discount window rate. Lets discuss.

Obviously, and I agree completely, cutting the target fed funds rate is an emergency option for the fed. Instead, the fed cuts the discount window today and offers a so called 'time-out' for markets. Let me first define the discount window and the fed funds target rate so you know the difference and exactly what Ben Bernanke did today.

Discount Window Rate - Discount window represents an instrument of monetary policy (usually used by central bank) that allows eligible institutions to borrow money, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions. The interest rate charged on such loans by central bank is called discount rate, and constitutes important factor in the control of money supply -- which is a significant tool of monetary policy. When a bank in the United States is in need of money, it can turn to the Federal Reserve for a loan, the interest that the Fed charges the bank is called the discount rate.

Fed Funds Target Rate - The federal funds rate is the interest rate at which private depository institutions lend balances (federal funds) at the Federal Reserve to other depository institutions overnight.

According to Yahoo Finance:

The Federal Reserve, declaring that increased economic uncertainty poses risks for U.S. business growth, announced Friday that it has approved a half-percentage point cut in its discount rate on loans to banks.

The action was the most dramatic effort yet by the central bank to restore calm to global financial markets which have been roiled in the past week by a widening credit crisis.

The decision means that the discount rate, the interest rate that the Fed charges to make direct loans to banks will be lowered to 5.75 percent, down from 6.25 percent.

The Fed did not change its target for the more important federal funds rate, which has remained at 5.25 percent for more than a year.

With this 50 basis point cut in the discount window, it is STILL 50 basis points ABOVE the fed funds target rate of 5.25%. Bernanke took another alternative move to cutting the target fed funds rate, which is the rate at which banks lend to each other overnight. As wikipedia puts it:

Another way banks can borrow funds to keep up their required reserves is by getting a loan from the Federal Reserve itself at the discount rate. These loans are very short term and rare, as they are subject to audit by the Fed and the discount rate is usually higher than the federal funds rate.

If anything it was the right rate to cut! It leaves the option for Bernanke to cut the fed funds target rate should things get real hairy down the road!

What does this move do?

1. It Adds Credibility - tells the markets that Bernanke & Co. are on top of the liquidity crisis in the banking system and willing to provide the liquidity needed to normalize the markets.

2. Provides Lift To Equities - stock futures first down big, reverse course and surge. Gives a great opportunity for those long equities to unwind some positions and puts shorts in a very bad situation of having to cover, further bullying the stock market.

3. Adds Liquidity To Banking System - alternative move gives more liquidity to the banking system and allows banks to borrow money on a short term basis, to meet temporary shortages of liquidity

4. Yield Curve Steepens - Banks like a steep yield curve so they can profit more. Todays fed move is steepening the yield curve, a good thing for banks

5. Brings Arbitrage Players Back - which helps the markets become more efficient. How long it lasts is another question.

It's important to note that this is NOT A PERMANENT FIX! This is going to have a temporary effect and in my opinion, gives investors a chance to unwind positions and banks a chance to fix their books a bit. It does not solve our credit problems longer term! I'll have to do follow up reports on this once the market opens and I need a chance to unload some long positions I have been building up over the past 4-5 days as the market sold off.

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