Effect of the Discount Rate Cut

The Fed cut the discount rate from 6.25% to 5.75% before trading opened Friday morning, and US stocks responded.  Green numbers showed up for the first time in weeks.  The Nikkei rebounded from its shocking fall on Friday.  But it is impossible to tell right now if the cut will provide a lasting calm to financial markets worldwide.

There is a possibility for the Fed’s decision to have a big, positive effect on the credit market.  Much of the liquidity crisis has been a result of the inability of securities firms to obtain loans based on their assets.  The Fed has announced that it will take asset-backed securities and mortgages as collateral for the thirty-day (maximum) loans.  Securities firms cannot go to the Fed directly, but they can go to banks with their goods and the banks can go to the Fed.  In theory, this should solve the problems of the credit crunch.

But if you check out how the discount rate is used in practice, you see that the effect of Friday’s decision may be pretty small.  Only $11 million dollars changed hands last week through use of the discount window, a laughably small number.  A rate decision cannot really affect the market if no one borrows at that rate.

The real effect of the discount rate cut is probably psychological.  The decision signals that the bank is ready to do something to ameliorate the liquidity crisis.  The FOMC statement on August 7 was hawkish and preoccupied with inflationary risks.  The Bernanke Fed has prided itself on transparency, and in order to leave itself the room to lower rates in September or October, the bank needed to alter that statement.  Ignoring the effect of the financial crisis was a rookie mistake, but the Fed fixed that problem without indiscriminately bailing out the idiots of the subprime crisis.

The effect this will have on the credit market depends on the Fed’s willingness to lower rates.  If they do not cut the Fed Funds rate in September, we will see a resumption of instability and dollar-bullishness.  But the effect on the equities market is a little more complex.  Risk aversion should trend downwards, allowing for greed to surpass fear as a market mover.  But the fundamentals of the global economy are still troublesome, as the housing problems haven’t exactly gone away.  So investors should be wary of volatility; the VIX index registered its highest level even after the discount rate announcement.

For the US dollar, the Fed’s concern with economic growth over price stability is bad news.  Traders will now value the greenback’s safe haven status less highly.  An easing of the monetary policy should promote growth in the United States over the longer term; we are already seeing American growth outpace European growth for the first time in years.  And that phenomenon should continue.  But with investors hungry for yield and with the forex market as competitive as it is now, we are looking at a bearish outlook for the US dollar.