The Funds Rate, Liquidity, and the Term Auction Facility
At its December 11 meeting, the Federal Open Market Committee (FOMC) voted to lower the target federal funds rate 25 basis points to 4.25 percent. This followed on the heels of a 50 basis point cut at its September 18 meeting and a 25 basis point cut at the October 30-31 meeting.
The committee supported the move by stating that “incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks.”
Prior to the meeting, participants in the Chicago Board of Trade’s federal funds options market thought there was a 70 percent probability that the Fed would announce a 25 basis point cut. The remainder thought that a more aggressive policy cut of 50 basis points would occur.
While the modest rate cut was not a big surprise to markets, the stock market fell nearly 2 percent after the Fed’s announcement. This large drop was probably due more to the Fed’s decision to keep the spread between the primary credit rate and the discount rate at 50 basis points rather than its decision to cut the fed funds target by only 25 basis points.
Many had expected the committee to lower the primary credit rate more aggressively in order to boost discount window borrowing. Discount window or primary credit borrowing is particularly important during times of financial crisis. While the statement mentioned the “strains in financial markets,” the fear was that the Fed was not doing enough to address those strains.
Signs of increasing financial strains included the widening spread between the London Inter-Bank Offer Rate (LIBOR) and a comparable short-term Treasury bill. LIBOR is the interest rate that the banks internationally charge each other for loans.
But what was not known at the time of the FOMC announcement was that more extensive efforts were already being planned to deal with these liquidity issues. At 9 a.m. on December 12 (the day following the meeting), a press release was issued that stated: “Today, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing measures designed to address elevated pressures in short-term funding markets.” One of the major changes for the Federal Reserve System was the institution of a “term auction facility” (TAF) to supplement regular discount window borrowing. This facility is designed to give the Fed greater control of how much borrowing will actually occur and to aid the channeling of funds to those financial institutions experiencing the greatest liquidity pressures.
Policymakers are concerned that banks are not borrowing enough at the discount window because of the so-called “stigma effect”—the belief that borrowing at the window is a signal that a bank is financially weak. If banks are afraid to come to the window when they need to, they might be forced to sell off assets quickly at fire sale prices because of immediate liquidity needs. The hope is that the term auction facility will lessen the stigma effect, thereby helping to ensure that banks that most need the loans will receive them.
The terms of the auction are to be as follows: “The minimum bid rate for the auctions will be established at the overnight indexed swap (OIS) rate corresponding to the maturity of the credit being auctioned. The OIS rate is a measure of market participants’ expected average federal funds rate over the relevant term.”
Setting the minimum bid to the OIS rate is pretty much the same as setting the minimum bid to an interest rate with no penalty. Of course, this is the minimum bid, and market forces will determine how large a penalty rate there will actually be.
The amount being auctioned off is quite substantial. “The first TAF auction of $20 billion is scheduled for Monday, December 17, with settlement on Thursday, December 20; this auction will provide 28-day term funds, maturing Thursday, January 17, 2008. The second auction of up to $20 billion is scheduled for Thursday, December 20, with settlement on Thursday, December 27; this auction will provide 35-day funds, maturing Thursday, January 31, 2008.” There will also be a third and fourth auction on January 14 and 28 of unannounced quantities. After that, “the Federal Reserve may conduct additional auctions in subsequent months, depending in part on evolving market conditions.”
One way to gain some perspective on the magnitude of the December 20 and December 27 credit auctions is to compare these amounts with Federal Reserve System repurchase agreements (REPOs). REPOs are collateralized loans from the Fed to dealers, typically for 28 days or less, used to supply reserves to the banking system.
The market reacted favorably to the announcement of the term auction facility. While stock prices had dropped around 2 percent following the fed funds rate decision, following the announcement of the TAF, stocks regained most of what they had lost. Later in the day, stocks retraced their earlier gains, but that was probably due to higher oil prices.
Financial stocks also benefited from the news, but interestingly, their increase was less than that of the broader market. Undoubtedly, other news had come out overnight, which was reflected in their opening price.
The two-year Treasury rate is thought to reflect current liquidity pressures as well as expectations of those of the future. Liquidity concerns raise the price (cut the yield) of safe assets such as the two-year Treasury bill, because investors turn to safer assets at such times. Prices on two-year Treasury bills increased substantially after the Fed rate announcement, but subsequently fell back down following the TAF announcement. Even in the time between the two announcements, some of the earlier declines had been erased, as there was speculation of a forthcoming Fed announcement.
Even with the cut in the funds rate and the introduction of the new term auction facility, the market is still betting on another cut at the end of January. Whether this cut materializes depends partly on whether the strains in financial markets lessen over the next six weeks. The hope is that they will, since some of the current pressures are probably because of year-end financing needs. The unwinding of these pressures, along with the past funds rate cuts and the new auction facility, will hopefully reduce these strains by the January meeting.