Fed cuts rates!!

By Kristen | Published August 17, 2007

Fed cuts discount rate to 5.75%

Central bank’s move aimed at easing credit crunch

By Rex Nutting & Mike Maynard, MarketWatch

Last Update: 12:26 PM ET Aug 17, 2007

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WASHINGTON (MarketWatch) — In a move applauded by financial markets on both sides of the Atlantic, the Federal Reserve announced Friday that it’s cut the discount rate by half a percentage point to 5.75%.

The Federal Reserve Board said it was acting to “promote the restoration of orderly conditions in financial markets.” The Fed also said it would allow banks to borrow unlimited funds at 5.75% for 30 days, down from the previous overnight rate of 6.25%. Read the Fed statement.

“It’s conceivable that the Fed’s actions today could go a long way toward restoring liquidity to the markets,” said David Greenlaw, an economist for Morgan Stanley.

By cutting the discount rate instead of the federal funds rate, the Fed signaled that it believes problems are mainly confined to the financial system, and are not yet impacting the broader economy. The cut in the discount rate provides funds to banks, but does little to change consumer and commercial interest rates, as a cut in the fed funds rate would do.

“Markets should not be calmed by this tactic,” wrote Carl Weinberg, chief economist for High Frequency Economics. “This move is not going to provide any relief to the overall economy.”

In a separate statement, the policy-setting Federal Open Market Committee acknowledged the precarious state of credit markets and the economy.

“Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth,” the FOMC said. See text of FOMC statement.

‘Markets should not be calmed by this tactic. This move is not going to provide any relief to the overall economy’

— Carl Weinberg, High Frequency Economics

Accordingly, the FOMC, led by Fed Chairman Ben Bernanke, said it “judges that the downside risks to growth have increased appreciably.” Fed officials are “monitoring the situation” and are “prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets,” the FOMC said.

After last week’s meeting, the FOMC had said it judged inflation to be a greater risk to the economy than slow growth. See full story.

In effect, the FOMC has shifted its policy bias, which had tilted toward a rate hike, to leaning toward a rate cut. Financial markets expect the FOMC to cut the fed funds rate in September.

U.S. stocks opened much higher. In the bond market, Treasurys weakened. See Market Snapshot.

The discount rate stood at 6.25% previously; it’s been set at one percentage point above the federal funds rate.

The discount rate is set by the seven members of the Federal Reserve Board, while the federal funds rate is targeted by the FOMC, which includes all the members of the Fed board, plus five of the 12 regional Fed bank presidents. St. Louis Fed President William Poole, who is a voting member this year, did not participate in the conference call because he was traveling. Dallas Fed President Richard Fisher took his place.

Poole had said Wednesday that only a “calamity” in the markets or economy would force the Fed to cut rates. See full story.

While the timing of the Fed’s action was a surprise, many investors and analysts had been expecting a rate cut since early August, when growing insolvencies in subprime mortgages sparked fears among investors that other types of credit could also default.

In response, investors began to sell risky securities such as mortgage-backed securities, commercial paper and corporate equities to seek the safety of Treasurys. Even the most qualified borrowers found it difficult and expensive to obtain credit.

The Fed took the “large and unusual” move because of “the plunge in commercial paper” market” and the “increased threat difficult financing conditions pose for viable businesses,” wrote Stephen Gallagher, economist for Societe Generale. The Fed’s action could provide a temporary alternative to the market for short-term financing needs, Gallagher said.

Worries about a broader impact

The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from regional Federal Reserve lending facilities. It differs from the key federal funds rate, which is the rate at which private institutions lend to other depository institutions overnight.

“We can only speculate about this, but the decision to move the primary discount rate rather than the fed funds rate may indicate that the Fed anticipates some institutional failure as soon as today, probably not a bank, but rather an institution that has substantial bank liabilities that may not be able to clear,” Weinberg said.

The discount window has rarely been used; only an average of $87 million is borrowed on an average day, said Tony Crescenzi, chief bond market strategist for Miller Tabak & Co. There has been something of a stigma attached to using the discount window, Morgan Stanley’s Greenlaw said.

“It is imperative that the Fed validate this largely symbolic but important action with a cut in the fed funds rate,” Crescenzi said.

The target for federal funds remains 5.25%.

Many economists expect the Fed to cut the fed funds rate at the FOMC’s next meeting, scheduled for Sept. 18.

The Fed has been providing extra liquidity to the markets on a temporary basis through its open-market operations but had vowed to keep the federal funds targeted at 5.25%.

Since the housing and credit bubbles began to deflate, dozens of lenders have gone out of business, several hedge funds have failed, and thousands of homes have gone into foreclosure.

(This is an update to correct the name and title of the economist from High Frequency Economics.)