Monetary Policy: Providing Liquidity
On December 11, 2007, the Federal Open Market Committee (FOMC) voted to lower its target for the federal funds rate by 25 basis points to 4.25 percent. On January 2, 2008, the FOMC released the minutes of its December meeting. In the minutes, the committee stated, “The information reviewed at the December meeting indicated that, after the robust gains of the summer, economic activity decelerated significantly in the fourth quarter. Consumption growth slowed, and survey measures of sentiment dropped further. Many readings from the business sector were also softer.” Meeting participants also “discussed in detail the resurgence of stresses in financial markets in November” and expressed concerns about liquidity problems in interbank markets.
On December 31, 2007, participants in the Chicago Board of Trade’s federal funds options market placed a 55 percent probability on a 25 basis point reduction and a 28 percent probability on no change in the funds rate at the FOMC’s end-of-January meeting. After the publication of the December minutes, several key data releases, and a speech by Fed Chairman Bernanke on January 10, these probabilities shifted significantly, tilting toward expectations of a more aggressive January rate cut. In his speech, Chairman Bernanke stated, “We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.” As of January 10, 2008, participants’ views indicated a 70 percent probability of a 50 basis point cut in the funds rate in January.
On December 12, 2007, between the FOMC meeting and the release of the minutes, the Federal Reserve announced the creation of a Term Auction Facility (TAF). The TAF was introduced to address “elevated pressures in short-term funding markets.” The TAF provides a new means by which the Federal Reserve can inject liquidity into the banking system. The belief is that the discount window, through which the Fed has historically made loans to financial institutions, has not always adequately accommodated periods of financial stress. It is thought that a financial institution may be reluctant to borrow through the discount window since such an action may be interpreted as a sign of financial weakness.
Open market operations can be another source of liquidity to the system. However, in recent months concern has arisen that funds made available through open market operations are not reaching those banks experiencing the greatest liquidity needs. It is hoped that the TAF will overcome the stigma effect of standard discount window lending and elicit greater borrowing as well as channel the funds to those who need them most. Furthermore, the TAF allows the Fed to inject funds through a broader range of counterparties and against a wider range of collateral than open market operations.
Under the Term Auction Facility, the Fed announces an amount of funds to be auctioned and a term for the loan, typically about a one-month maturity. A minimum bid rate is determined by the level of the overnight indexed swap (OIS) rate near the time of the auction. (The OIS rate is typically where the market expects the funds rate to average over the period.) Funds are auctioned to generally sound financial institutions that are eligible for primary credit through the Fed’s discount window. The final TAF rate is determined by the auction. Greater detail on the Term Auction Facility can be found on the Board of Governor’s website.
Two auctions for a total of $40 billion have been conducted so far. Bids for the first auction of $20 billion began December 17, with a minimum bid rate of 4.17 percent. A total of over $61 billion in propositions were submitted from 93 bidders. The awarded loans settled on December 20, with a maturity date of January 17, 2008. The stop-out rate (or the winning bid) was 4.65 percent. The remaining $41 billion in bids were less than 4.65 percent (but more than 4.17 percent).
The Fed conducted another $20 billion auction on December 20. Funds available through this auction will mature on January 31, 2008. The minimum bid rate was 4.15 percent. Seventy-three bidders submitted propositions totaling over $57 billion, and the stop-out rate was 4.67 percent.
Two more auctions are currently slated for January 14 and January 28. Both of these auctions will be for 28-day loans of $30 billion each. On January 4, the Fed announced that it “intends to conduct biweekly TAF auctions for as long as necessary to address elevated pressures in short-term funding markets” and would make known their decisions regarding February auctions on February 1.
Both of the December auctions had stop-out rates only 8 to 10 basis points below the primary credit rate of 4.75 percent, yet generated a quantity of loans far in excess of outstanding primary credit. This seems to imply the program does mitigate the stigma problems associated with standard discount window loans.
Despite the auction of $40 billion of loans in December, the level of temporary open market operations remained elevated through the end of 2007. Primary credit outstanding, although small relative to the combined total of TAF lending and temporary open market operations, also was at historically high levels at year’s end. The total amount of temporary liquidity provided by the Fed near the end of 2007 reached levels far above that of recent years and rivals the quantities provided around the century date turnover (Y2K) and immediately following the terrorist attacks of September 11, 2001. However, both primary credit outstanding and temporary repurchase agreements have fallen markedly in the first week and a half of 2008.
The Federal Reserve normally increases their provision of liquidity to help accommodate typical end-of-year funding pressures. The end of the year also can be associated with fairly substantial deviations of the federal funds rate from its target. These deviations are exacerbated when the system is simultaneously experiencing unusual liquidity demands for other reasons. For example, during the Y2K period and following the Long-Term Capital Management/Russian default crisis of 1998, large deviations of the federal funds rate from target were observed. In 2007, financial turmoil associated with developments in mortgage markets added liquidity pressures on top of typical year end needs.
The minutes from the FOMC’s December meeting stated, “A number of participants noted some potential for the Federal Reserve’s new Term Auction Facility and accompanying actions by other central banks to ameliorate pressures in term funding markets.” These participants may be encouraged by recent movements in the spread between the London Inter-Bank Offer Rate (LIBOR) and the short-term Treasury rate. As of December 20, this spread was at 2.48 percent. Since then it has fallen nearly a percentage point and a half to 1.03 percent. Nonetheless, the LIBOR spread remains above levels of recent years.