Fed’s Discount Rate Among Tools to Offset European Sovereign-Debt Crisis

The Federal Reserve could if necessary dig deeper into its toolkit to ease the sovereign-debt crisis in Europe, by cutting the U.S. discount lending rate or restarting a program that auctions loans to banks.

Six central banks led by the Fed yesterday lowered the cost of emergency dollar funding for financial companies, reducing the premium banks pay to borrow dollars overnight from central banks by half a percentage point to 50 basis points.

The Fed may reduce what it charges on emergency loans to banks by a quarter point to 0.5 percent by early next week, said Michael Cloherty, head of U.S. interest rate strategy at RBC Capital Markets. It probably won’t resort to its other options, including reopening the Term Auction Facility to give U.S. banks more access to funding, without a worsening in Europe’s crisis, said Charles Lieberman, chief investment officer with Advisors Capital Management LLC in Hasbrouck Heights, New Jersey.

“The Fed is willing to be active if it thinks that’s necessary,” said Lieberman, a former head of monetary analysis at the New York Fed. “But I think the Fed will move a bit more cautiously, unless conditions weaken further in Europe. The U.S. side is looking much better.”

The U.S. central bank raised the so-called discount rate to 0.75 percent in February 2010. Yesterday’s cut in the swap rate, which takes effect Dec. 5, means European banks will pay about 0.60 percent to borrow dollars, cheaper than what U.S. banks would pay. The Fed is unlikely to let that situation persist, Cloherty said.

“Just to level the playing field, we would expect a 25 basis point cut” in the discount rate, he said.

Coordinated Action

Richmond Fed President Jeffrey Lacker, who dissented from the coordinated action, said yesterday that he opposed making the swap rate lower than the discount rate.

The Fed will want to avoid the appearance of bailing out foreign banks or shifting U.S. monetary policy, said Robert Eisenbeis, former research director at the Atlanta Fed and now chief monetary economist in Atlanta for Sarasota, Florida-based Cumberland Advisors Inc. He put “zero probability” on buying foreign debt.

“I think the liquidity problem is one in Europe and the swaps will deal with that,” he said. “A domestic move would be seen as a monetary-policy move and also a move to bail out foreign banks, whereas the swaps program is viewed differently and done with zero risk and without requiring collateral.”

While the European Central Bank is buying the bonds of debt-strapped governments such as Italy and Spain, it says the purchases are limited, temporary and aimed solely at restoring the effectiveness of its interest rates on financial markets. It has bought 203.5 billion euros ($273.5 billion) of bonds since the purchase program began in May last year.

‘What’s Necessary’

“Most of what’s necessary right now is in European hands,” Lieberman said. “I find it hard to understand how the Fed would justify buying European sovereign debt if the ECB is reluctant to do so.”

Bringing back the Fed’s Term Auction Facility would allow U.S. banks to get funding if needed, while avoiding the stigma of borrowing at the Fed’s discount window, said Michelle Girard, senior U.S. economist at RBS Securities Inc. in Stamford, Connecticut.

“If there end up being funding difficulties for U.S. institutions, I do think that the Fed in the past obviously has employed various liquidity facilities, and some of those could be reopened if in fact we saw U.S. institutions facing some difficulties in funding,” Girard said.

Coordinated Effort

The new interest rate instituted by central banks is the dollar overnight index swap rate plus 50 basis points, and the program was extended by six months to Feb. 1, 2013, the Fed said yesterday in a statement in Washington. The Fed coordinated the move with the European Central Bank as well as the Bank of Canada, Bank of England, Bank of Japan, and Swiss National Bank.

“Everything is on the table right now, but I think they will try to wait to have bigger impact with or without other banks,” said Diane Swonk, chief economist for Mesirow Financial Inc. in Chicago. “Right now, our banks are doing OK on funding, so an immediate cut in discount rate shouldn’t be necessary.”

The Fed said in its statement that U.S. financial companies “currently do not face difficulty obtaining liquidity in short- term funding markets.”

“However, were conditions to deteriorate, the Federal Reserve has a range of tools available to provide an effective liquidity backstop for such institutions and is prepared to use these tools as needed to support financial stability and to promote the extension of credit to U.S. households and businesses,” the central bank said in the statement.

To contact the reporter on this story: Steve Matthews in Atlanta at smatthews@bloomberg.net Scott Lanman in Washington at slanman@bloomberg.net

To contact the editor responsible for this story: Chris Wellisz at cwellisz@bloomberg.net

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