Magazine article Economic Trends

Providing Liquidity

Magazine article Economic Trends

Providing Liquidity

Article excerpt

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01.14.08

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.

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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.

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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. …

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