Fed believed to be considering unconventional tools for bailouts

Fed Mulls Options in Tackling Liquidity Problem

By Krishna Guha
Financial Times, London
Wednesday, September 12, 2007

http://www.ft.com/cms/s/0/07b9cb8e-615f-11dc-bf25-0000779fd2ac.html

WASHINGTON -- As Federal Reserve policymakers look ahead to next week's decision on interest rates, staff at the central bank are continuing to work on other potential steps that could be taken to address liquidity problems in financial markets.

The possible steps range from the relatively orthodox -- a disproportionately large cut in the discount rate at which the Fed lends directly to banks -- to more unorthodox measures.

At issue is whether it would be worth the Fed dusting down some rarely used tools -- or improvising new ones -- to help it reach beyond the banking system and channel liquidity to where it is needed most.

Ben Bernanke, the Fed chairman, flagged up the possibility in a speech at Jackson Hole earlier this month when he said the Fed "stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets."

The obvious step would be to cut the discount rate by more than the main federal funds rate. For instance, if the Fed cut the funds rate by 25 basis points, it could cut the discount rate by 50 or even 75 basis points, reducing (or in the latter case eliminating) the effective penalty on direct borrowing.

This would both encourage greater use of the discount window facility and make it a more effective back-stop for the money markets.

The Fed has already cut the discount rate by 50 basis points to reduce the direct borrowing penalty. The aim is to make banks feel comfortable lending to non-bank financial institutions against good collateral, by letting them know they will in turn be able to raise funds from the Fed against that collateral at reasonable rates.

The discount rate is set by the Washington-based board of governors, not the full federal open market committee, so there is no reason why the Fed would have to announce any change alongside the rate decision next Tuesday. But a number of analysts expect that it will.

Some also believe the Fed might consider extending the term of its open market operations, as the European Central Bank has done.

Meanwhile, work is believed to be continuing on more unconventional policy steps that could be deployed if required in the future.

Fed officials see ensuring the effective functioning of markets as a critically important mission but one that is distinct, at least in the first instance, from their other main mission of managing the macroeconomy.

So they are keen to revisit the liquidity support tools at their disposal -- tools that in many cases are rusty from lack of use over the years.

There are a number of ways in which the Fed could try to reach beyond the banks to the stressed non-bank financial sector and the distressed markets for asset-backed commercial paper and non-agency mortgage-backed securities.

Indeed, some of these approaches have been tried in the past, as Richard Berner, chief economist at Morgan Stanley, points out in a recent research note.

One option would be to set up a facility to lend directly to non-banks against their collateral, loosely modelled on the joint lending programme put in place in 1989 at the height of the savings-and-loans crisis.

Another option would be to establish currency swaps with European central banks to deal with pressure on the offshore dollar money markets, similar to those put in place after the terrorist attacks of September 11, 2001.

The Fed could also mimic measures used in 1999 to guard against the fear of a Y2K liquidity drought at the turn of the millennium.

These included the creation of a temporary special liquidity facility that would accept commercial paper at a discount and the sale of call options giving banks the right to tap Fed loans in the future if required at guaranteed rates.

None of these steps appears imminent but their use should not be ruled out, particularly if markets take a fresh turn for the worse.

Mr Berner said the Fed's main concern would be to ensure it did not end up taking any credit risk and that any unorthodox arrangements were truly temporary.

"It is like a military operation -- you need an exit strategy," he said.

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