Financial Update (Second Quarter 2008)

Examining the Federal Reserve's New Liquidity Measures

Board of Governors graphic As the economy has slowed in the last nine months and credit markets have become unstable, the Federal Reserve has taken a number of steps to help address the situation. These steps have included the use of traditional monetary policy tools at the macroeconomic level as well as measures at the level of specific markets to provide additional liquidity.

The Federal Reserve's response has continued to evolve since pressure on credit markets began to surface last summer, but all these measures derive from the Fed's traditional open market operations and discount window tools by extending the term of transactions, the type of collateral, or eligible borrowers.

New efforts include modifications and new initiatives
Since August, the Federal Reserve's Board of Governors has reduced the discount rate for primary credit—the rate at which financial institutions can borrow from the Fed—from 6.25 percent to 2.5 percent. Similarly, the Federal Open Market Committee (FOMC) has reduced the target federal funds rate—the rate at which financial institutions borrow from each other—from 5.25 percent to 2.25 percent.

Audio icon The Fed's Liquidity Measures podcast (MP3 10:44)
Dec. 12, 2007, Federal Reserve actions off-site image
Information about central banks' coordinated efforts off-site image
Information about new Fed liquidity initiatives off-site image
FRBNY press release about Bear Stearns's acquisition by JPMorgan Chase off-site image

The Federal Reserve also has implemented other changes to address liquidity issues. The recent changes to the Fed's liquidity provision have modified the terms of the primary credit program of the discount window (DW) and the introduction of three new facilities: the Term Auction Facility (TAF), the Term Securities Lending Facility (TSLF), and the Primary Dealer Credit Facility (PDCF).

The suite of facilities now in place, according to the Federal Reserve Bank of New York, should enable a set of institutions that play an important role in financial markets to access liquidity from the Federal Reserve against collateral they would normally finance easily with other financial market participants.

The tools, which are described below, should reduce risks to financial stability and strengthen the effectiveness of monetary policy in addressing risks to the outlook for growth and inflation.

Access to two types of facilities
With the introduction of these new facilities, eligible depository institutions and primary dealers now have access to two complementary types of facilities.

The discount window for depository institutions and the PDCF for primary dealers are effectively "standing" facilities, according to the New York Fed, that provide daily access to funding for eligible institutions. Access to funds through these facilities occurs at the initiative of the borrowing institution, in an amount determined by the borrowing institution's needs and collateral. The Fed charges a fixed interest rate set at a premium to market rates on this type of facility to discourage institutions from unnecessary use of Fed lending.

The TAF for depository institutions and the TSLF for primary dealers constitute a second type of facility in which a predetermined amount of longer-term funding is available at auction on preannounced dates for settlement on a later date. These facilities are designed to improve overall liquidity conditions in term and secured funding markets rather than to satisfy the needs of a particular institution on a particular day. The interest rate and the distribution of the awards across institutions in this second type of facility are determined by an auction.

Liquidity offset through open market operations
Liquidity provided through these facilities is offset in the implementation of monetary policy through open market operations so as to achieve the FOMC's federal funds target rate. As a result, these facilities enable the Fed to alter the composition of its balance sheet to address strains in market conditions but also allow it to use its other reserve management tools to maintain any particular overall size it desires for banking system reserves and hence the federal funds rate.

Ongoing support by the Fed
The Federal Reserve will keep this new array of liquidity facilities in place for as long as is necessary.

In his testimony before the Committee on Banking, Housing, and Urban Affairs of the U.S. Senate, Federal Reserve Chairman Ben Bernanke summed up the Fed's role in facilitating JPMorgan Chase's acquisition of the Bear Stearns investment bank as well as other Fed actions. "The purpose of our action, as with our other recent actions—including our provision of liquidity to financial firms and our reductions in the federal funds rate target—was, as best as possible, to improve the functioning of financial markets and to limit any adverse effects of financial turmoil on the broader economy," he said. "We will remain focused on those objectives."

April 15, 2008