Maybe it’s time to revise the textbooks on money and banking. For decades the Federal Reserve has implemented monetary policy by way of three primary tools: open market operations, the discount window, and reserve requirements. But the recent market volatility has forced the Fed to rely on a fourth tool: the term auction facility (TAF). It’s a tool with great promise.
The Federal Reserve Bank of St. Louis, an excellent source for reserve bank data, has made no mention of TAF being the new driving force behind Fed policy. However, a detailed exhibit from the Fed Board of Governors provides clear evidence of just how important TAF has become in staving off financial catastrophe.
A traditional way to assess emergency Fed activity has been to monitor bank borrowings through the discount window. But over the years the discount window has become increasingly less effective. Big borrowings from the window usually take place at year-end, when consumers fund higher retail sales activity. Over the past twenty years, total peak borrowings from the window never exceeded $4 billion — a paltry sum in comparison to overall member-bank borrowings. The discount window has also come to be seen as sign of weakness, since users of the window must pay the penalty rate, or the discount rate (which has been well above the fed funds rate), and are subject to increased bank inspections.
The recent explosion of borrowing through TAF may very well mean the auction process is now preferable to borrowing from the discount window.
Here’s how TAF works: According to the Fed governors, under TAF
the Federal Reserve will auction term funds to depository institutions. All depository institutions that are eligible to borrow under the primary credit program will be eligible to participate in TAF auctions. All advances must be fully collateralized. Each TAF auction will be for a fixed amount, with the rate determined by the auction process (subject to a minimum bid rate). Bids will be submitted by phone through local Reserve Banks.
Bids submitted through TAF in December 2007 totaled $57.7 billion. By March 10, 2008, that amount had increased to $92.595 billion. Since these data were released, the Fed has extended its lending facilities to primary securities dealers, another important move. The reason for this change was the impending collapse of a leading primary securities dealer, Bear Stearns. In future weeks we could see substantial increases in these statistics based on the heightened borrowing needs of these dealers.
All of this signals a sea change in Fed policy. With TAF, monetary policy can now be focused on specific financial crises that are unrelated to overall economic conditions. During the last economic downturn, the Fed lowered its fed funds rate to 1 percent, hoping to stimulate business activity through low-cost money. As a result, the combination of significantly low interest rates and tax cuts triggered the housing bubble that became the primary cause of today’s numerous financial market problems. Yet even though the Fed is back lowering its target rate as recessionary signs persist — the funds rate now stands at 2.25 percent — the pinpoint targeting of financial crises allowed by TAF may reduce the chance of potentially ruinous financial bubbles ever developing.