Federal Reserve & Interest Rates

Frederic S. Miskin, member of the Federal Reserve Board of Governors gave a speech Friday discussing the financial instability of our nation and the reasoning behind actions that the Federal Reserve has taken both historically and recently.

Miskin explained e responsibility of the Federal Reserve in response to financial instability. He says, “The interest of the Federal Reserve in financial stability does not arise out of a concern for the functioning of financial markets as such or out of a desire to aid distressed investors or institutions. Rather, the Federal Reserve vigorously promotes financial stability because of the intimate connection between a stable financial system and solid macroeconomic performance. The financial system, comprising financial markets and institutions, channels funds to those individuals or firms that have productive investment opportunities.”

According to Governor Mishkin, there are four main ‘shocks’ that can at as ‘catalysts’ in financial instability.

• sharp increases in interest rates
• the deteriorating of corporate and household balance sheets
• weakened financial intermediaries
• problems in the banking sector

“Central banks typically inject liquidity into the system via the banking sector, but the intent is clearly to have the liquidity spread from there…injections of liquidity have the potential to directly address the causes of financial instability and therefore to counteract the pernicious effects of financial instability on broad macroeconomic conditions.”

He went on to discuss financial crisis in the past mentioning issues including the Panic of 1907 and the Stock Market Crash of 1987. He cited methods and examples of the efforts of the Federal Reserve to provide liquidity to the financial system.

While discussing the financial instability that currently faces our nation, Governor Mishkin stated, “Although the provision of liquidity is undoubtedly a useful tool, it is not without potential costs.” He went on to explain that this type of action might create and incentive for banks to increase the amount of investment risks that they are willing to take on. If similar actions are improperly handled, it can lead to further financial instability. The Federal Deposit Insurance Corporation Improvement Act of 1991 limits the lending ability of the Federal Reserve to troubled banks to keep that kind of moral hazard from occurring.

With all of that said, there is still a 50/50 chance that there will be another rate cut this week. The FOMC meets at the end of this month and investors and economists are still wondering what the Federal Reserve will do next. Is this speech a foreshadowing of another drop in rates as a move of the Reserve to increase financial stability? Or is Governor Mishkin saying that further moves to help the troubled markets at this time would cause moral hazard? In just a few more days we shall see if there will be any further moves.

Things are starting to calm down now, after the trouble in the financial markets over the passed two weeks. Thanks to the actions of the Federal Reserve, of course.

According to the press release on Friday, August 17, 2007, the Federal Reserve Board approved a reduction of the discount rate.

“The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility–the discount window. The Federal Reserve Banks offer three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. All discount window loans are fully secured.”

Before the change, the rate was 6 ¼ %. The new rate is 5 ¾ %. The rate was effective as of Friday for the Federal Reserve Banks of Dallas, Kansas City, Minneapolis, Chicago, Atlanta, Richmond, Cleveland, Philadelphia, and Boston. The rate was effective Monday, August 20, 2007 for the Federal Reserve Bank of St. Louis.

Sources say the main motivation for the change was to “mitigate the adverse affects on the economy arising from the disruptions in financial markets.” In other words, if the markets are allowed to do poorly for too long, the entire economy suffers, so they had to do something. In order to keep the markets lively, the Federal Reserve put a total $45 billion in the banking system over the passed two weeks. The reduction in the discount rate was yet another move to stabilize the market.

It kind of makes you wonder if this means that monetary policy is getting looser, doesn’t it? There is criticism out there about the whole situation. If cutting the rate and injecting extra money into the system is honestly for the good of the economy, so be it. The concern is that if the Federal Reserve is coming to the aid of banks that made faulty risks, it makes them look like parents that spoil their children.

Is the Federal Reserve simply giving their baby banks extra money because they wined for it? You can form your own opinion, but I don’t think so. Giving the markets a boost for the sake of having an upbeat market would be wrong. Maintaining stability in the economy should be, and hopefully is, the sole motivation for the infused billions and the cut rate that the Reserve has made. In a very indirect way, the move helps keep money in our possession.

Economists are calling the move ‘symbolic.’ That is to say that the action looks good for the larger economic picture, but doesn’t directly impact the finances of the little guy.

Monetary policy is not permanently altered by this change. In fact, this is supposed to be a temporary adjustment until the market gains some liquidity. The move should be seen as a minor adjustment that doesn’t change the position of certain policy statutes. Future performance of the financial markets will determine whether or not other reductions will be made.

After yesterday’s performance in the market, investors can finally wipe the sweat from their foreheads and take a deep breath.

The market is looking good for now. Economists say that the change will probably not directly affect consumers. The credit market would be in danger of seizing if something had not been done. Cash flow needs to be in the banks because if it is not in the banks, it can’t get to us. Even though we aren’t getting a direct interest rate break, this move by the Federal Reserve is keeping money accessible to us.

The lowering of the discount rate reduces the cost of emergency lending. It makes money more accessible to lenders as it is needed.
Smaller banks will also benefit from the extra cash flow in the system.

Is the change permanent? This change is supposed to be temporary, but who knows? The markets have to get back to a healthy fluid state before rates go back up. There is some speculation that this action was a sign that rates will also go down for the policy rates as well.

For now, the adjustment seems to be helping Wall Street. After a month, we will have to see how things pan out. The next scheduled FOMC meeting is on September 18th. This discount rate adjustment will more than likely be on the table for discussion. Was it a good idea? I guess we will have to wait and see. Hopefully, the economy will pull through, the markets will stay on the up and up, and inflation won’t get out of hand. Only time will tell.