Thursday, December 13, 2007

Fed Announcement and Your Classroom

Yesterday, the Federal Reserve System, in cooperation with a number of other central banks, announced a program that would provide additional liquidity to a financial system under strain because of the U.S. sub-prime issue.

They announced the creation of a Temporary Auction Facility (TAF). This facility is meant to provide a channel for banks to borrow funds from the Fed. At this point, you (or your students) may ask how it differs from the primary lending facility (discount window). I will try to offer some possible answers based on what I understand from reading the statement.

Similarity to discount window: The TAF is open to financial institutions that can access the primary lending facility, i.e. those financial institutions deemed to be in good financial condition.

Similarity to discount window: Loans from the TAF are collateralized. This means that the borrowing institutions must put up high-quality (read low-risk) securities as collateral for the loan. This is the same as at the discount window.

Difference from discount window: The term or length of time for loan from the TAF is different. Discount window loans are very short term (frequently overnight). TAF loans will be for periods closer to one month.

Difference from discount window: The process will be based on auction, as opposed to simple application. At the discount window, if you show up and have proper collateral (and you're a qualified institution), you get the loan. At the TAF, there will be an auction for the limited supply of funds. There will be a minimum bid price (rate of interest), and it will be competitive - higher rate bids will have a higher likelihood of being accepted. There will also, as I read it, be non-competitive bids. Financial institutions submitting this type of bid will pay an average rate based on the accepted competitive bids. This is similar to the way the Fed and the Treasury conduct auctions of Treasury securities whenever the Federal government needs to borrow money. In those circumstances, the Fed acts as the Treasury's agent, helping to collect bids and distribute securities.

One of the more interesting institutional aspects of the statement, as I read it, is that the Fed is leaving the door open for the TAF to become a more permanent aspect of its lending channels. That decision will arise out of this temporary experience as well as public comment.

The long and short of it, I don't think you need to change the "three tools of monetary policy" to "four" quite yet. On the other hand, if your students are participating in the Fed Challenge competition this year, you might want to watch further developments on TAF and its ability to provide liquidity. The issue could make an interesting one for judges to ask in Q&A.

I sincerely hope a number of my former Federal Reserve colleagues, who have access to more information than I do, will comment with any corrections or clarifications. I would also direct you three blogs that frequently do a good job of Fed-watching. The first belongs to a good colleague of mine at Western Illinois University, Dr. William Polley. The second is one that has only been around since September but is still very interesting. It is hosted by a portfolio manager in New York named Marc Shiver. The last is by former Dallas Fed President and current Distinguished Fellow at the National Center for Policy Analysis, Bob McTeer. I suspect all of them will have far better insights to offer than I have.

I look forward to comments.

Here's a speech by New York Fed President, Tim Geitner that explains the TAF.


julie said...

Tim, I emailed various explanations of the Fed announcement to my Macro students and to former Fed Challenge team members. In the subject line of the email I wrote: "New tool for monetary policy???"
Some of us have followed Bernanke since he was a Governor of the Fed, read his speeches during the "deflation" concern in 03 and know of his research and writings on the Great Depression. Earlier this fall there were hints the Fed was considering other ways to address the liquidity crisis than cuts in the Fed funds rate. Thanks for the timely information.

Mike Fladlien said...

tim would you explain how the fed can lower the fed funds rate and the market react so negatively? thanks flad