Most Federal Reserve policy actions are transparent: The central bank buys or sells government securities daily to either increase or decrease the required reserves banks must hold at the Fed. This process tends to drive the federal funds rate (the interest rate at which member banks of the Federal Reserve System lend to one another) up or down. Over the past few years the Fed has gradually decreased or increased the funds rate to influence the direction of the economy. Using a boxing analogy, the Fed uses a left jab most of the time. It’s somewhat annoying, but it gets the job done.
Every once in a while, however, the Federal Reserve takes the role of “lender of last resort.” When unusual financial crises emerge, the Fed steps in with a characteristic “straight right to the head,” and thereby relieves most of the pressures emanating from that crisis. The mechanism for this direct approach is the discount window. Regardless of Fed policy on maintaining interest rates, the Fed will offer reserves to member banks through the discount window in a process that is designed only for temporary purposes. The discount rate is usually a lot higher than the fed funds rate, and banks will resort to such borrowing only when absolutely necessary.
The stock market crisis of 1987 is a clear example of how important the Fed can be as a lender of last resort. As a mutual-fund manager during October of that year, I remember how certain trading techniques were beginning to undermine the smooth functioning of the equity markets. Given these techniques, market risk came in the form of specialists on the New York Stock Exchange. When these specialists became illiquid on October 19 and the morning of October 20 due to increased program trading, one stock at a time ceased trading and the stock market as we know it was about to close down.
I went to lunch early that October 20, expecting the market would have collapsed around the time I got back. Not only did my worst fears not materialize, the market rallied strongly. Fundamentals hadn’t changed, but the word on the Street was that the Fed had stepped in to give the specialists as much money as they needed to maintain stability in the stock market. Once the word got out, the market rallied and never looked back. A knock-out policy response, as I saw it.
The double-bubble problem of sub-prime mortgages and leveraged institutional investors recently provided the circumstances for another strong right hand. For the first time in memory, a global “lender of last resort,” including the U.S. Fed and the European Central Bank, stopped a financial market meltdown after fears of liquidity crises froze traditional lenders. When the global “feds” offered liquidity, the institutional borrowers took the offer to the tune of at least $300 billion (so far). No, the Fed didn’t fly over the country in a helicopter dumping dollars on the economy. Instead it surgically responded to demands for liquidity to avoid a financial crisis.
History will look favorably on how central banks around the world responded to this serious credit crisis. Of course, there are always those who condemn the U.S. Fed for either being too tight or too easy. Yet the current U.S. Federal Reserve has maintained a stable interest-rate policy in the face of economic data that indicates a solid economy. In my opinion, the Fed has helped avert the economic collapse that would undoubtedly have followed a financial market collapse.
This Fed, along with other central banks, is landing it punches.