There were several messages intended in the Federal Reserve’s unusual inter-meeting twin statements of Aug. 17 after the US Federal Reserve cut its discount rate and admitted, for the first time, that the credit market crises had the potential to inflict damage on the economy. Was this a doomed last charge of the Seventh Cavalry or does it herald a U-Turn in the Fed policy of raising interest rates to curb inflationary trends? What direction this takes has implications for Saudi monetary policies and domestic interest rates, given the Saudi riyal’s peg to the dollar.
By cutting the discount rate by 50 basis points to 5.75 percent, and extending the maturity of the lending to as long as 30 days, instead of requiring repayment the following day, the Fed was responding to the persistent severity of the credit market dislocations. Despite some massive central bank liquidity injections, two developments were becoming apparent: First, that the liquidity being provided through the open market operations was simply not reaching a whole swathe of financial institutions that needed it the most, which was threatening deeper dislocations, and; second and tightly linked to the first, indications of that deeper dislocation was, indeed, surfacing in sectors like the jumbo mortgage market to creditworthy borrowers, which was effectively shutting down. In simple terms, the few rotten sub-prime mortgage apples were beginning to affect the good ones.
The hope is that by lowering the discount rate — the interest rate the Fed charges to banks who come to its so called “discount window “ to borrow cash using commercial security as collateral will remove some of the stigma in tapping the window and will thus offer the wider financial community direct access to central bank liquidity. But probably the real target with the discount window decision is to prod the big institutions to begin lending more again instead of hoarding the liquidity provided by open market operations. The major fear, as argued elsewhere by this writer, is to what extent, lower down the financial chain , has real damage been done by the credit crunch.
With both the ongoing open market operations and access to the longer maturity borrowings of the discount window and its wider choice of acceptable collateral, financial institutions should feel more secure about their funding through mid-September. The intention for the open market desk also remains to bring fed funds rate to or as close to its 5.25 percent target as soon as possible.
Beyond the very near term needs addressed with the discount window decision, the second statement was, in effect, an inter-meeting “update” to the Aug. 7 communiqué. The intention was to signal a shift in the balance of risk assessment from a predominant concern for inflation risks — right past “neutral” or a balanced assessment — to an unmistakable bias to the downside, in stating “the downside risks to growth have increased appreciably.”
Furthermore, by issuing the tweak to the outlook in a separate statement, the Fed wanted to drive home the distinction it has been trying to make between short- term, temporary liquidity measures to ensure the market is functioning smoothly and monetary policy, whose primary instrument of the fed funds rate is directed in response to changes in the outlook for the real economy. However there is some danger in the Fed’s action — was the US Central Bank right to come to the rescue of financial institutions in this way, or could it not allow the best and fittest to survive and punish those that had committed lending errors by letting them fail?
The problem with bailing out failing institutions, is that it creates a “moral hazard “ problem — whereby those that are bailed out with no penalties for bad lending will act accordingly and quickly forget the lessons of their failures.
For investors and borrowers in the Kingdom, the discount rate cut will not bring any immediate relief in current interest rate levels, as the key indicator is whether the fed fund rate will be cut back in September’s FOMC meeting. Local rates are still running at a small premium to dollar interest rates , but the spreads have narrowed recently due to some liquidity injections both by government spending and private sector inward transfers.
Concerning local financial institutions, they have not been exposed to the subprime mortgage fiasco, but most new domestic borrowers should not be surprised to see a more rigorous credit application process now being applied, as local bankers learn the lessons of overseas easy credit approvals.
While the discount rate cut not meant as a pre-meeting commitment to a Fed Fund rate cut, that the committee stated it will be “monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets,” was meant to convey that the Federal Open Market Committee (FOMC) is leaving the door open to a cut in the fed funds rate — if needed.
More to the point, the twining of the Fed statements is meant to convey very low probabilities of an inter-meeting cut in the fed funds rate and that any decision on rate policy is much more likely and ideally suited for the upcoming Sept. 18 meeting, when the FOMC will have the full in-depth analysis of the economy and the outlook.
(Dr. Mohamed Ramady is visiting Associate Professor, Finance and Economics, King Fahd University of Petroleum and Minerals).