Staying the Course
In a unanimous vote, the Federal Open Market Committee (FOMC) voted to keep its target fed funds rate steady at 2 percent. In its statement, the FOMC recognized that "Strains in financial markets have increased significantly..." While noting that credit conditions had tightened, the statement concluded, "Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth."
Just last week, most market participants took the no-change outcome as a given. However, financial market developments over the weekend sent shockwaves through the whole financial system. By Monday, options and futures prices on the fed funds rate indicated that odds slightly favored a rate cut of at least 25 basis points. But that was not to be.
The dramatic collapse of Lehman Brothers, the hasty sale of Merrill Lynch to Bank of America, and the appeal of AIG for aid changed all that. Concerns about liquidity and systemic risk, which had been rising, intensified. One closely watched indicator of liquidity conditions, the spread between the term borrowing rate in the London interbank market (Libor) and the cash market rate (OIS), reflected these developments. The spread for one-month borrowing had declined considerably from recent peaks; however, recent turmoil in financial markets has caused the spread to increase substantially.
Rather than addressing this liquidity problem with a change in the policy rate, the Fed decided to continue to rely on its several lending facilities. The New York Federal Reserve Bank added $50 billion in liquidity to money markets through overnight repurchase agreements, known as repos. In addition, the Trading Desk, which conducts open market operations on behalf of the Federal Reserve, said in a statement that it "stands ready to arrange further operations later in the day, as needed."
The markets backed off on an expectation for a rate hike at the FOMC's next meeting in October. The odds for the no-change outcome moved to better than even.