Tuesday, December 16, 2008

Is the TAF the new discount window?

Today the Fed will release its one-page statement on interest rate targets by the Federal Open Market Committee (FOMC) and the Board of Governors, a subset of the FOMC that sets the discount rate. Many have written off the importance of the FOMC’s decision in favor for the wording of the release: the Globe and Mail (Canadian Paper) says it perfectly, Fed funds rate cut seen as 'mostly ceremonial'. On the contrary, I see the discount rate cut announcement as largely ceremonial.

I wonder if the Fed isn't phasing out the discount window in favor of its new policy tool, the Term Auction Facility (TAF). Unless the discount rate is cut aggressively, banks will continue to get funding primarily from the TAF. The TAF lending rate moves more in line with the effective funds rate, which is close to zero, rather than the discount rate, which is not.

The Fed has increased the size of the TAF by $445 billion since December 2007 – a substitute for discount funds – but has increased discount window lending by just $87 billion over the same year. I expect that eventually the Fed will phase out the discount window in favor of the TAF, as the TAF determines the lending rate using an auction mechanism while the discount rate is only set periodically by the Board of Governors.

The TAF rate moves in line with current market conditions, while the discount rate cannot.

The chart illustrates the stop-out rate for the TAF auction (the loan rate determined through an auction mechanism), the discount rate set by the Board of Governors, and the effective federal funds rate (the market rate for interbank lending) on a weekly basis since the beginning of the year. What has become very clear in the last month is that the TAF lending rate (the stop-out rate) is more highly correlated with the effective federal funds rate than with the discount rate.

Initially, the TAF was thought of as a substitute to the discount window since the TAF offers similar terms to the discount window, including maturity lengths and collateral obligations. But recently, the TAF auction is looking more like a substitute for the federal funds market, as the stop-out rate is 0.83% below the current discount rate (1.25% at the time of posting).

Banks can borrow funds from the Fed at 0.49% for up to 84 days (depending on the auction), hold the funds as reserve balances, and all the while, receive 1% interest on those reserves. An interesting arbitrage opportunity with the Fed?

Furthermore, the bid to cover ratio (# bids received/# bids accepted) has dropped off in the last month. The Fed has been holding weekly TAF auctions, and demand for funds is falling accordingly.

The Fed may be phasing out the discount window as its primary source of direct bank lending in favor of the TAF (see first chart). It will be interesting to see how the Board of Governors sets the discount rate in today’s FOMC announcement. I believe that an insignificant reduction would imply that the Fed plans to continue with its TAF lending aggressively - since the effective federal funds rate is almost zero - and perhaps eventually phase out the discount window all together.

Rebecca Wilder


  1. The fed will have to abandon its interest payments if it's going to lend that low.

  2. This is a great point.....The equity market awaits a "decision"...it's really no decision at all ....The damage has already been done to the Fed Balance Sheet. It makes no difference....except perhaps to the US Dollar.

    Wouldn't the lack of a cut be considered beneficial for holders of our currency as the spreads aren't widening ? It would seem to me that this might be the only reason for the FED to hold on the FFunds rate ?

  3. I agree with David. We posted a story along the same point that the impending news of a rate cut, isn't really "news" at all. The reduction of the Fed Funds rate has done little for consumers. Lenders have taken minimal advantage of the large spreads, really only serving to recover previous losses.


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