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Fed Cut Eyeing The Discount Rate

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by Yves Smith and Felix Salmon
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Sep 18 2007 12:00am EDT

Fed Cut: Eyeing the Discount Rate

OK, no more Greenspan blogging, I hope. Instead – rate cut blogging! Obviously I have no idea what the Fed will do this afternoon, or even really what it should do. But my gut feeling is that Bernanke should announce a nominal 25bp cut in the Fed funds rate to 5% (hell, it averaged 5% in August anyway) along with a more substantial 50bp or even 75bp cut in the discount rate. Greg Ip notes today that "many on Wall Street feel the Fed has yet to make the discount window attractive," especially given that the spread between the Fed funds rate and the discount rate has been widening thanks to the lower-than-target funds rate.

Justin Lahart, on the other hand, says it might not be as easy as all that:

Many market participants expect a large discount-rate cut, but there is a caveat that the Fed might find too large to ignore: If such a cut leads to a substantial increase in borrowing at the discount window, the influx of cash onto banks' reserve balances could push the federal-funds rate well below its target.

I'm not sure I understand. As I understand it, the Fed controls the Fed funds rate through open-market mechanisms. In times of extreme volatility or illiquidity, that control might not be perfect, but if the Fed wanted to raise rates right now, it could. In principle, is there any reason why the discount rate can't be as low as – or even lower than – the Fed funds rate?

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