Wednesday, August 22, 2007

The Fed's Discount Window

In the mists of antiquity when Monk and I took Economics in high school and had wonderful teacher affectionately named the Old Bastard we were taught that the Fed discount window was not to be used by banks except in dire emergencies. As a matter of fact, the Fed did not want to see direct borrowing from the Fed except when an institution was under extreme duress.

That has held true for a long time.

That changed last week after the Fed surprised the market by reducing the discount rate 50 basis points (0.5%) to 5.75% and ENCOURAGED institutions to use the facility. So far Bank of America, Citigroup, JPMorganChase, Deutsche Bank and Wachovia have used the discount window even though cheaper financing was available elsewhere to confirm that using this facility no longer carries a stigma.

The discount rate move and subsequent events were intended to have a signalling effect, i.e., that the Federal Reserve is offering itself as a lender of last resort and is willing and happy to do it. The rate cut has certainly stabilized the market and is a good thing.

Note that the discount rate is different than the Fed Funds rate which is the target rate that the Fed sets for banks lending reserves kept at the Fed to each other.

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