South-Western College Publishing - Economics  
It’s Ok to Borrow from the Fed
Topic Monetary Policy
Key Words Discount Window, Discount Rate, Federal Funds Rate
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Reference ID: A167915773

News Story The Federal Reserve normally uses open market operations to conduct policy that will loosen or tighten credit markets. When they announce an increase or decrease in the benchmark federal funds rate they back that action up by buying or selling securities in the open market. The Fed has two other measures at its control for applying monetary policy but they seldom use either.

The reserve ratio, one of the other two tools, is a rate set by the Fed that requires banks to hold a certain percentage of their deposits on reserve. This percentage is seldom changed and seldom used as a tool of monetary policy.

The third, and seldom used tool, is the discount rate. The discount rate is the rate the Fed charges to loan money directly to banks. Recently the Federal Reserve lowered the discount rate and loosened its collateral standards in an effort to inject more money into the credit markets.

Historically there has been a stigma attached to borrowing from the Fed. This action of visiting the discount window has been seen as a sign of weakness and a possible indicator of trouble ahead. In fact, the discount window was considered as a lender of last resort when funds could not be obtained elsewhere. “Going to the discount window is like someone on the Upper East Side being seen in a Wal-Mart,” said Charles R. Geisst, a financial historian at Manhattan College. “The T-shirts may be cheap, but why would you?”

Normally banks borrow from each other in the federal funds market. When one bank has excess reserves they lend them to other banks that need excess reserves. These loans are generally short-term, overnight loans. The Fed is trying to make the discount window just as acceptable as the federal funds market for banks in need of loans.

The four banks that went to the discount window for funds are Citigroup, Bank of America, JPMorgan, and Wachovia. “I think it is a show of solidarity with the Fed’s objective of removing any taint of borrowing from the discount window.” said Paul McCulley, a portfolio manager at Pimco, a big fixed-income money management firm. “There was no obvious need for any of those institutions to borrow. “

By encouraging these large banks to use the discount window and by promoting it as a sign of strength the Fed hopes to change public perception and improve the effectiveness of this previously seldom used tool of monetary policy. “If you have a pipe to get liquidity in the system but nobody will use it, that limits its effectiveness,” Mr. McCulley said.

Wachovia, Bank of America, and JPMorgan issued a joint statement saying they were using the discount window in an effort to “encourage its use by other financial institutions.” In a separate statement Citigroup said it was “pleased to inject liquidity into the financial system” and would “stand ready to continue to access the discount window as clients and needs warrant.”

This issue will be watched closely by analysts, especially those who still see borrowing from the Fed as a sign of weakness. Those are the folks who still see the possibility of troubles ahead.

Questions
Discussion Questions:
1. Name and define each of the three tools of monetary policy.
2. Visit http://www.federalreserve.gov/monetarypolicy/discountrate.htm and identify the three different types of lending that occur at the discount window.
Multiple Choice/True False Questions:
1. The discount rate is:
  1. the rate banks charge their best customers.
  2. the amount of deposits banks must hold on reserve.
  3. the rate banks pay to borrow from the Fed.
  4. Vnone of the above.
2. Historically, borrowing from the Fed:
  1. was seen as a sign of weakness.
  2. has been limited to credit unions.
  3. was preferred to borrowing from another bank.
  4. None of the above.
Source Eric Dash, “Four Major Banks Tap Federal Reserve for Financing”, The New York Times Online, August 23, 2007.
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