Friday, August 17, 2007

The Fed approaches its senses

by Ken Houghton

One of the silliest moves during the Bush administration was 2003's policy change that left the "Discount" rate higher than Federal Funds. (Discussed here; the short version is that any "moral hazard" was always mitigated by the transparency of the act itself.) Temporarily, they have seen the error of their ways, and taken a halfway measure of action:
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.

Of course, they're also making it easier for firms that lack proper liquidity management to survive:
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. [emphasis mine]

This is, not to put too fine a point on it, a Monetary Policy Mistake. While providing emergency liquidity can be justified, this is simply a Revolving LoC to perpetuate poor management practices.

After 11 September 2001, the Fed made small business loans available to several NYC-area firms, loans that gave firms a chance to get their finances in order and back on their feet. But those loans were not renewable, and firms that could not adjust to the new market wound down anyway, as part of the "creative destruction" so feted by "free"-marketers. The effect of the loans was to make that destruction orderly, not to prevent it from happening.

Now, at 9:34 a.m., the immediate effect of the Discount Rate cut is that the stock market (Dow and NASDAQ) are massively up. To borrow a theme from The Sandwichman (at Max's Place), the idea that the "loan of last resort" is worth at least a 2.5% gain in the markets should in itself produce "a slight sense of unease."

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