Behind Bernanke's Bombshell

The Fed joins with other central banks to boost global liquidity. But the timing of the move has raised eyebrows in financial markets

by BW, Standard & Poor's, and Action Economics staff

One day after it announced reductions of one-quarter percent to two key U.S. interest rates (BusinessWeek, Dec. 11) -- a move that prompted a sell-off in U.S. equity markets on Dec. 11 -- the Federal Reserve dropped a bombshell on Wall Street: The central bank, in conjunction with its counterparts in Europe and Canada, unveiled a series of measures designed to inject added cash into global money markets in hopes of thawing a credit freeze that threatens major economies.

In a press release (BusinessWeek, Dec. 12), the Fed said it has joined the European Central Bank, the Swiss National Bank, and the Bank of Canada to create a new "term auction facility" under which it would lend at least $40 billion and potentially far more, in four separate auctions starting this week. The loans would be at rates far below the rate charged on direct loans from the Fed to banks from its so-called "discount window." The new loans can still be secured by the same, broad variety of collateral available that banks pledge for discount window loans.

The move, which was announced before the start of trading Dec. 12, initially sent major stock indexes sharply higher. Investors turned skeptical and bid stock prices lower late in the session befoe a sudden reversal in the closing minutes of trading enabled indexes to close in positive territory.

First new auction on Dec. 17

The Fed said all banks judged to be in generally sound financial condition by their Fed regional bank would be eligible to participate in the auctions for funds. The first auction is scheduled for Monday, Dec. 17, with settlement three days later, with a total of $20 billion. Another $20 billion will be auctioned on Dec. 20, settling Dec. 27. Auctions will also be held Jan. 14 and 28, with the amounts to be determined after the first two auction results are seen.

The Fed said that the new auction process should "help promote the efficient dissemination of liquidity" when other lines of credit were "under stress." The experience gained from the four scheduled auctions would be "helpful in assessing the potential usefulness" of this new process to provide funds to U.S. banks, the central bank said. It said that the temporary swap arrangements being set up would provide up to $20 billion in reserves for the European Central Bank and up to $4 billion for the Swiss National Bank. The reserves would be available for a period of up to six months.

At a Dec. 12 press briefing, a Fed official said banks using the new term auction facility won't be identified, according to an Action Economics report, though the Fed insists there should be no stigma attached to participating institutions.

"In a nutshell, the central banks will auction liquidity funding directly to a broad segment of commercial banks, and these commercial banks will be able to pledge a wide variety of collateral," wrote Wachovia (WB) chief economist John Silva in a Dec. 12 note.

An end to the crunch?

Silva expressed optimism on the move. "In our view, today's action has the potential to end the crunch that has paralyzed the credit market for the past few months", he wrote.

Standard & Poor's chief economist David Wyss says the coordination among the central banks seems like very good news, but the actual function of this auction facility remains unclear.

A question of timing

The timing of the Fed's move has raised eyebrows in financial markets. "The FOMC disappointed markets Tuesday with a timid 25 [basis point] cut in [the] discount rate and a policy statement that showed no leadership and which failed to give the markets confidence needed during this time of credit turmoil", writes Action Economics. "Why didn't [the] Fed make such an announcement yesterday is the big question in the markets, especially those who were whipsawed by yesterday's and today's huge market moves."

What next for interest rates? Based on Dec. 12 trading in Fed funds futures, a quarter point reduction in the funds rate to 4% is fully priced in to the market. The July implied rate suggests a 3.5% funds target is possible by midyear, says Action.

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