Fed Cut: Eyeing the Discount Rate

OK, no more Greenspan blogging, I hope. Instead – rate cut blogging!

Obviously I have no idea what the Fed will do this afternoon, or even really

what it should do. But my gut feeling is that Bernanke should announce a nominal

25bp cut in the Fed funds rate to 5% (hell, it

averaged 5% in August anyway) along with a more substantial 50bp or even

75bp cut in the discount rate. Greg Ip notes

today that "many on Wall Street feel the Fed has yet to make the discount

window attractive," especially given that the spread between the Fed funds

rate and the discount rate has been widening thanks to the lower-than-target

funds rate.

Justin Lahart, on the other hand, says it

might not be as easy as all that:

Many market participants expect a large discount-rate cut, but there is a

caveat that the Fed might find too large to ignore: If such a cut leads to

a substantial increase in borrowing at the discount window, the influx of

cash onto banks’ reserve balances could push the federal-funds rate well below

its target.

I’m not sure I understand. As I understand it, the Fed controls the Fed funds

rate through open-market mechanisms. In times of extreme volatility or illiquidity,

that control might not be perfect, but if the Fed wanted to raise rates right

now, it could. In principle, is there any reason why the discount rate can’t

be as low as – or even lower than – the Fed funds rate?

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