WASHINGTON — When the Federal Reserve Board's monetary policy arm meets today, its action on the often-overlooked discount rate could serve as a signal of whether the central bank is rethinking where that particular tool fits in its response to the liquidity crisis.
As the credit market suddenly soured over the summer, the Fed moved on Aug. 17 to slash the discount rate, hoping banks would turn to the discount window for funds, feel more confident about lending again, and, in turn, ease worries on Wall Street. But nearly four months after the Fed's surprise discount rate cut, many observers say its plan has not panned out.
"It has not sufficiently resolved the issue," said John Lonski, the chief economist for Moody's Investors Service. "The takeaway is that anxiety remains elevated in the interbank loan market, and that poses a risk to the adequacy of credit."
Borrowing from the discount window has been sporadic since the August discount rate cut. Lending to healthy institutions surged to $7.152 billion on Sept. 12, marking the highest level of borrowing since the Sept. 11, 2001, terrorist attacks. But borrowing fell to $1.115 billion by the next week and to as low as $2 million in November before growing again, to $2.108 billion, on Dec. 5.
If the Fed wants to prove it will work to help with liquidity, many observers said it should cut the discount rate more aggressively than the federal funds rate — effectively putting meaning back into the word "discount" — when it meets today.
They blame the sluggish response to the discount window on a 2003 change the Fed made in how it charged for these loans. Previously, the Fed provided sub-market-rate loans through the discount window but subjected any borrowers to stern questioning, leaving the tool as a possibility only for banks in dire shape.
The Fed now provides loans to healthy institutions with few questions asked at 50 basis points over the fed funds rate. The idea was that if banks pay more for the loans, there will not be a stigma and the institutions will not be judged by Wall Street.
But industry representatives say the current credit problems prove that adding a "penalty" rate above the cost of fed funds makes using the window prohibitively expensive.
That is especially true as cheaper sources of liquidity grow, including the Federal Home Loan bank advances, which surged 28.6% in the first nine months of 2007 thanks to the credit crunch.
"If you want to get liquidity into the market, you need to get rid of this penalty," said Keith Leggett, a senior economist at the American Bankers Association.
Former Comptroller of the Currency Eugene Ludwig argues the Fed has several tools to make the discount window more helpful.
"The Fed has wisely recognized that its hands are not tied; they have options," said Mr. Ludwig, who now heads Promontory Group. "They can eliminate the penalty rate for discount window borrowings. They can change the character of the use of the discount window. They can coordinate access to the discount window by reserve banks more closely."
But Gil Schwartz, a former Fed lawyer who monitored discount window transactions and now works in private practice, dismissed calls to bring the discount rate below the fed funds rate.
"The Fed wouldn't want to be seen as subsidizing banks," he said. "You can put as much liquidity out there as you can, and if bankers say 'I don't care,' you can't force them to lend."
One concern said to be on Fed officials' minds is that if the discount rate were lower than interbank alternatives, it could interfere with information the central bank currently gleans from fluctuations in the London interbank offered rate and other market-based rates about risk perception in the marketplace.
The discount rate moves in tandem with the fed funds rate, which most observers expect will be cut 25 basis points.
While that would result in a 25-basis-point cut to the discount rate as well, the most likely scenario may be further narrowing without sending the discount rate below the fed funds rate, observers said.
"In view of how monetary policy operates with a lag and given that we do have large amounts of subprime adjustable-rate mortgages scheduled to reset in 2008, the Fed should perhaps cut the discount rate by 50 basis points," Mr. Lonski said. "Not only does that widen the net interest margins of banks and make banks willing to assume credit risk, it also gives a boost in confidence for financial institutions, businesses and consumers."
Fed officials are currently divided on whether the current discount rate cuts have worked as intended.
The central bank asked for — and received — help from the four largest domestic banks — Citigroup Inc., Bank of America Corp., JPMorgan Chase & Co., and Wachovia Corp. — as each borrowed $500 million from the window in August. But they quickly repaid the loan and emphasized they were not borrowing because of impending problems at their companies.
In part, the help from the big banks was meant to remove the stigma of discount window borrowing. The central bank also allowed term financing to make it easier to borrow from the window.
Despite those actions, Fed officials say the stigma still clearly exists.
Though Fed officials say they do not judge the discount rate cut's success just by borrowing levels, some acknowledge the uneven response raises questions about how the central bank can effectively inject liquidity into the market during troubled periods.
"The usefulness of the discount window as a source of liquidity has been limited in part by banks' fears that their borrowing might be mistaken for accessing emergency loans for troubled institutions," Fed Vice Chairman Donald Kohn said in a speech last month.
"This stigma problem is not peculiar to the United States, and central banks, including the Federal Reserve, need to give some thought to how all their liquidity facilities can remain effective when financial markets are under stress."
But days later, Charles Plosser, the president of the Federal Reserve Bank of Philadelphia, told reporters he felt the August cut worked.
"The discount window cut was actually a good thing, more effective I believe than it would seem if you only looked at how much borrowing in fact went on," he said. "I look at it as part of what we were doing in sending a signal to the markets that we were there, that we were prepared to lend, we were prepared to take credit, they were welcome to the window and we weren't attaching any stigma to it."