Federal discount rate cut from 6.25% to 5.75% - Attempt to ease credit crunch in the market

THE FED
Fed cuts discount rate to 5.75%
Central bank's move aimed at easing credit crunch
By Rex Nutting & Mike Maynard, MarketWatch
Last Update: 9:42 AM ET Aug 17, 2007

WASHINGTON (MarketWatch) -- In a move wildly applauded by financial markets on both sides of the Atlantic, the Federal Reserve announced Friday that it's cut the discount rate to 5.75%.
The Federal Reserve Board said it was acting to "promote the restoration of orderly conditions in financial markets."

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

"Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth," the FOMC said.

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.

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

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

In effect, the FOMC has shifted its policy bias from tilted toward a rate hike to tilted toward a rate cut.

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.

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's 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.

The discount window is rarely used; only an average of $87 million is borrowed on an average day, said Tony Crescenzi, chief bond market strategist for Miller Tabak & Co.

"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.

By cutting the discount rate instead of the fed 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.

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

Cutting the rate -- something that financial commentators have been agitating for in recent days -- was seen as aimed at narrowing the gap between the discount and fed-funds rates.

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 bubble began to unwind, dozens of lenders have gone out of business, several hedge funds have failed and thousands of homes have gone into foreclosure.

The U.S. central bank also announced a change to the Federal Reserve Banks' usual practices designed to allow discount window loans for as long as 30 days, renewable by the borrower, instead of just overnight.

In this way, the Fed said it will be able to keep tabs on market liquidity.

These changes, the Fed said, are expected to afford banks and financial institutions "greater assurance about the cost and availability of funding."

In addition, the Fed will continue to accept a broad range of collateral for discount-window loans, including securities backed by home mortgages and related assets, in line with requests by the boards of directors of the New York Fed and the San Francisco Fed. Existing collateral margins will be maintained as well.