Why the Fed Will Cut 50bp Today

We now strongly believe the Fed will most certainly cut the benchmark Fed funds rate again today by another 50 bps. This is in addition to the massive emergency 75bps cut announced last week.

We have a sound basis for such a bold argument. Not least because the market itself is betting on that.

Implied probabilities of different outcomes. Source: Cleveland Federal Reserve

There are other subtle hints as well that can be picked up by a more discerning eye. The biggest of them all is the January 25 announcement for the fourth and the last planned Term Auction Facility on January 28. The Fed started accepting bids Monday on $30 billion of 28-day credit at a minimum bid set at 3.10%. Remember the current Fed funds rate is at 3.50% and the current rate at the discount window is 50 bps higher at 4.00%. This implies that the Fed is willing to loan reserves to member banks at the specified rate of 3.1%.

If we call our previous discussion on this topic , TAF is the discount window in a new avatar. Most of the collateral rules are the same for the TAF as for the discount window and both are processed through the twelve regional reserve banks. The only significant difference is how the rate is set. TAF involves a bidding process and is for a fixed term, while discount window is at a fixed rate. Having said that, TAF involves none of the stigma attached to the discount window ('you only borrow from the Fed when nobody is ready to lend to you').

We had hoped, rather surmised, that the TAF would succeed in bringing credit spreads back to earth. Indeed, as we have seen, credit spreads have indeed normalized since the TAF was introduced. So the exercise seems to have worked alright.

So what makes us think 50 basis points? If we look at the three auctions conducted thus far, the Fed has positioned the TAF minimum bid between its expectations of Fed funds rate and its expectation for the discount window rate. The rationale behind this is intuitive. It is implied that there should be some sort of a penalty for using a direct access to raw cash reserves directly from the central bank. But nonetheless, the penalty has to be lesser than that at the abandoned discount window.

So if the Fed keeps the Fed funds rate unchanged (3.5%) or cuts it only by 25 bps to 3.25% today, it would have effectively provided the TAF funds to member banks at a subsidy, rather than at a penalty. Remember that the Fed is a lender-of-last-resort and the TAF is pretty much its last-resort facility, with the discount window apparently not serving the purpose.

To be consistent with modern central banking practices, the Fed must cut the Fed funds rate by at least 50 basis points today. Failure to do so would be tantamount to rewriting time-tested rules of monetary policy. An event of this magnitude would further discredit this Bernanke Fed after all the criticism heaped on it over the past week. Also, excessive market volatility would be a obvious effect if the Fed stays put as investors would realize that the Fed's policy-making apparatus has become inconsistent and unpredictable... hardly what the Fed wants to do in the midst of an unrelenting credit crunch.

Further, it must set the discount rate such that it is higher than the minimum bid rate. If it does otherwise, a situation would be created where the TAF borrower would have paid a penalty above the discount rate by using the TAF instead of availing the discount window.

Lastly, the Fed would be eager to dispel the widely held belief that the emergency inter-meeting rate cut last week was prompted by the possibility of a major sell-off in the equity markets. Another 50 basis points cut would assuage fears of the Fed backstopping equity market punters as well as signal its seriousness in tackling the unraveling economy. If the Fed needed one shot at getting ahead of the curve, today is it.