Supplying Liquidity: The Tried and True and the New
On April 30, 2008, the Federal Open Market Committee (FOMC) voted to lower its target for the federal funds rate by 25 basis points to 2 percent. Since this latest round of rate cuts began in September 2007, the federal funds rate has been lowered a total of 3.25 percent. The FOMC’s statement noted that “economic activity remains weak” and that “financial markets remain under considerable stress.” The committee also pointed to some improvement in core inflation but cautioned that “energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months.” Richard Fisher and Charles Plosser preferred no change in the funds rate and voted against the committee’s action.
In the days prior to the meeting, participants in the Chicago Board of Trade’s federal funds options markets placed around a 70 percent probability on a 25 basis point cut at the April meeting. Nearly a 25 percent probability was placed on no change.
The options market places over a 70 percent probability on a pause at the June meeting. Looking further ahead, participants in the federal funds futures market have raised their projected path of the funds rate in recent weeks. Currently, participants in the futures market foresee little change in the funds rate over the next few meetings.
With the onset of financial turmoil in the fall of 2007, the Federal Reserve has implemented a number of facilities to enhance market liquidity and the functioning of financial markets. December brought the introduction of the Term Auction Facility (TAF), which auctions a predetermined amount of funds to depository institutions that are eligible for primary credit. Total bids for TAF funds continue to exceed the amount offered by nearly 2 to 1, even though the biweekly auction sizes were increased to $50 billion in March. In contrast, the April 10 and April 24 Term Securities Lending Facility’s (TSLF) auctions of securities were undersubscribed, with bids totaling less than the amount offered. Under the TSLF, which was introduced in March, the Trading Desk of the New York Fed lends liquid Treasury securities to primary dealers in exchange for a broader set of collateral.On May 2, the Federal Reserve announced changes to the TAF and TSLF facilities. Beginning May 5, the size of the biweekly TAF auctions will be increased from $50 billion to $75 billion. In addition, securities eligible as collateral for Schedule 2 TSLF auctions will be expanded to also include AAA/Aaa-rated asset-backed securities.
On March 16, the Federal Reserve announced a new lending facility “to improve the ability of primary dealers to provide financing to participants in securitization markets.” The Primary Dealer Credit Facility (PDCF) went into operation on March 17 for a period of at least six months. Under the PDCF, the Fed makes loans to primary dealers at the primary credit rate. These loans are collateralized by a wide range of investment-grade securities. Primary dealer credit outstanding peaked at nearly $40 billion at the end of March but has since declined to under $20 billion. There also has been substantial use of the discount window by depository institutions in recent weeks, with primary credit outstanding averaging around $10 billion during April. In contrast, primary credit outstanding has averaged $400 million since the facility was introduced in January 2003.
Despite the new liquidity-providing facilities, measures of liquidity pressures remain elevated. One such measure is the spread between the three-month Libor rate, the rate at which banks lend to each other in the wholesale London money market, and the rate on a comparable 90-day Treasury security. This spread has been volatile throughout this year and is currently at historically high levels.
Funds supplied by the Term Auction Facility, primary credit, and the Primary Dealer Credit Facility provide reserves to the banking system and can therefore potentially affect the federal funds rate. In order to keep the funds rate at the target set by the FOMC, the Trading Desk must drain reserves to offset the impact of those facilities. This has not come from a reduction in repurchase agreements (repos) conducted by the Desk. Repos remain elevated due to the introduction of single-tranche-term repos on March 7. This represented another effort to increase liquidity in term funding markets. However, the Desk has drained reserves through outright sales and redemptions of Treasury securities. Since the beginning of December 2007, total outright holdings of securities in the Fed’s System Open Market Account (SOMA) have fallen over $230 billion. The mix of securities in the portfolio has also changed due to the liquidity facilities’ provisions. The proportion of highly liquid Treasury bills in the Fed’s portfolio has fallen from 34 percent to 13 percent since the beginning of December 2007.