Expect the Fed to Correct Liquidity Dosage

The liquidity spasm of 2007 will have a more muted economic impact than other financial crunches in American history due to a similar crisis that took place 100 years ago. The Panic of 1907 led to the creation of a National Monetary Commission which eventually resulted in the Federal Reserve Act of 1913. The act created the Federal Reserve System, with the purpose of ensuring "a more elastic currency" to cushion the economic impact of periodic financial crises.

The discount-rate cut last Friday by the Federal Reserve Board and the unscheduled announcement by the Federal Open Market Committee (FOMC) that it "is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets" reinforce what should have been taken on faith, or at least on speculation, by seasoned market veterans: The lender of last resort is on the job.

A quick review: The discount rate, reduced by 50 basis points to 5.75%, is the rate at which commercial banks can borrow directly from the Fed against a broad range of collateral. That collateral can include treasuries and agencies, municipal and corporate securities, CDs and commercial paper, and bank loans including residential mortgages, so long as they meet credit standards set by the regional Federal Reserve district bank.

As a matter of regulatory power, the Fed can rewrite its rules to allow it to rediscount anything it chooses, including subprime loans and/or the kitchen sink, but as a matter of good practice, it is unlikely to allow onto its books, even temporarily, any merchandise that is or was not creditworthy. It would hardly be modeling its preferred standards if it did so.

Calling the Plumber

The announcement also highlighted "a change to the Reserve Banks' usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower (emphasis added). These changes will remain in place until the Federal Reserve determines that market liquidity has improved materially. These changes are designed to provide depositories with greater assurance about the cost and availability of funding."

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Jim Griffin is economic consultant and portfolio adviser to ING Investment Management and its Hartford-based unit, ING Aeltus, which manages institutional investment accounts and acts as adviser to the ING Mutual Funds. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. While Griffin cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.