A (Mostly) Symbolic Move by the Fed

The Fed's moves today were largely symbolic, but expectations and psychology matter in financial markets. The headline-grabber was the cut in the discount rate, the interest rate at which the Fed will make loans directly to banks. The discount rate is far less important than the Federal Funds rate - the rate at which banks loan reserves to each other - which the Fed tries to keep near an announced target level through its open-market operations.

The discount rate is somewhat of a vestigial organ of monetary policy. Back in the day when the Fed was much more secretive, changes in the discount rate were considered important as a signal of the Fed's intentions. After the Fed began announcing its targets for the Fed Funds rate in 1995, the discount rate has been much less prominent (I don't even mention it in my principles class). Borrowings from the discount window are relatively small - according to FRED, an average $132 million (that's million with an m) per month so far this year - because the Fed keeps the discount rate above the Fed Funds rate and there is somewhat of a stigma attached to it (i.e. it might be taken as a signal that a bank is having problems if it has to use the discount window).

The Fed is also temporarily changing the rules - this may be more important than the rate cut itself and lead to more use of the discount window. From the press release:

The Board is also announcing 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. 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. The Federal Reserve will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets.

Real Time Economics has a roundup of the Wall Street reaction. Perhaps more important was this announcement from the FOMC, which suggests a cut in the Fed Funds rate may be in the offing:

Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.

NB: The Fed Funds Rate target is set by the FOMC, while the discount rate is set by the Federal Reserve Board.
Update: Charles Wyplosz says the Fed's move is "innovative and shrewd." However, Willem Buiter and Anne Sibert believe the Fed has missed an opportunity.