The Role Of The Central Bank
On Tuesday, Fed Chairman Ben Bernanke gave a speech on the role of central banks at a conference at the Federal Reserve Bank of Atlanta.
A sharp housing contraction has generated substantial losses on many mortgage-related assets and a broad-based tightening in credit availability. Consistent with its role as the nation’s central bank, the Federal Reserve has responded not only with an easing of monetary policy but also with a number of steps aimed at reducing funding pressures for depository institutions and primary securities dealers and at improving overall market liquidity and market functioning.
The Fed’s traditional approach to monetary policy was ill equipped to handle the strains the housing contraction caused on the financial system. It had to initiate a number of new policies to combat the liquidity crisis that many financial institutions were facing.
Besides cutting interest rates to make the cost of credit cheaper, the Fed also reduced the spread to 25 basis points between the federal funds rate, the rate at which banks lend to each other and the discount rate, the rate at which banks borrow from the Fed. During the current credit crisis banks have been reluctant to lend to each other due to mistrust of their counter parties solvency.
The discount window has also been opened up to non-commercial banking institutions for the first time, providing a credit backstop to investment banks. They have also had to combat the stigma many financial institutions face that conditions are so bad that they must borrow from the discount window in the first place.
The Fed has had to pump large amounts of monetary funds into the financial system through it’s various auction facilities. It has also increased the range of collateral it is willing to accept, basically providing a market for mortgage related securities that have grown increasingly illiquid as investor confidence has deteriorated.
While confidence in the credit markets may be slow to return, the Fed has instilled confidence with investors that the central bank will take any step necessary during times of financial stress.
