Aug 17 2007
The Downside of the Incremental Approach
Just woke up to the news that the Fed has lowered its discount rate (NOT the federal funds rate as I first thought).
Couple of thoughts:
1. Apparently, the Fed adopts an incremental approach
2. However, if all else fail and the Fed has to use its last bullet–the federal funds rate, will such an action still carry the same impact as it would have without those incremental procedures?
3. The William Poole (the only Fed President I’ve met in person) side show is rather interesting. He seems to be a likeable nerd who is not very politically sensitive.
In FOREX class, I learned the overshoot phenomenon where an interest rate change causes a disproportionally larger movement of exchange rates. The deeper underlying explanation seems to be the sudden-ness of a change carries a premium.
In the exchange rate case, when the traders hear the sudden interest rate change, they need to be overcompensated in order to stay in the market. My point is: if the news comes in infinite piece meal, it may lose its thundering effect that could be the kick needed.
Other notes:
I wasn’t too sure of the difference between the two rates until I read Ip’s “primer“:
Until a few years ago, the discount rate was set below the fed funds rate and loans were subject to numerous conditions. Banks were reluctant to access the window because it was associated with a stigma usually reserved for distressed banks. A few years ago the Fed overhauled the discount window to try and alleviate that stigma; … Discount lending averaged just $11 million in the week ended Aug. 15. Although that was up from $1 million in the prior week it was puny compared to the billions of dollars the Fed has regularly injected into the financial system through open market operations.