Some Thoughts on the Credit Crunch

What is it, a credit crunch?

I note that the term "credit crunch" is emerging as the label of choice for most people who talk about the recent turmoil in credit markets.  That was also the term used in the early 1990s in the aftermath of the S&L and banking crises.  However, back then Fed policymakers were reluctant even to use the term and held out longer than just about everyone. When they did give in, they used "so-called" or put quotation marks around the offending noun.

I was one of three Fed presidents asked to testify before a Congressional committee about its impact in our region.  As I recall, I was the only one of the three to accept the term-certainly to use it without quotation marks.  Later on, when all the Fed presidents were "invited" to testify before the Senate Banking Committee, I was the first to use the term in my prepared remarks, which prompted the Committee Chairman to interrupt my testimony to ask questions about it. 

My point:  Fed watchers can gain some insight into Fed thinking by listening carefully to the language and labels used by policymakers. Denials of reality often show up in the language including the use of terms like "so-called" and the use of quotation marks on words used freely by everyone else.

(I'm basing this on memory, so I can't swear to the details on a stack of Bibles.  I do believe it's accurate, however.)

Which is better suited to deal with a credit crunch-the discount rate or the Fed-funds rate?

Normally, the discount rate is better for a couple of reasons.  Borrowing at the discount window is done at the initiative of the borrowing bank; so the funds are more likely to go where needed. And, unless offset with open market operations, the new reserves to the borrowing banks will also represent an expansion of reserves to the banking system as a whole.  When banks get reserves from other banks in the Fed-funds market, they are just swapping around existing reserves.  Reserves gained by some banks will be lost to other banks.

Cutting the target Fed-funds rate is a more general, less focused, action.  It will stimulate the economy as a whole, and may be needed, but the impact on what's causing the credit crunch will not be very direct.

Was the Fed's reduction in the discount rate a good idea?

Yes, it was an excellent idea.  However, as it turned out, it led to very little borrowing.  This tells me that the problem wasn't one of liquidity where firms needed to convert sound, but illiquid, assets into cash. Neither is it reluctance to borrow.  Instead, the problem is turning out to be a reluctance to lend, based on uncertainty and fear of loss-fear that they won't be paid back.

If the problem was a reluctance to borrow, it might be helped by lower interest rates because borrowers like lower interest rates. But a reluctance to lend is not helped by lower interest rates. Lenders like high interest rates, along with the expectation of repayment. Lower rates are hardly an incentive to a scared lender.

Does this mean the Fed shouldn't lower the Fed-funds rate on September 18?

No, the Fed should lower the Fed-funds rate because it will stimulate the economy and help prevent or cushion a recession.  It may also help ease the shock of new mortgage resets.  However, I don't expect a general easing of monetary policy to have much direct effect on the credit crunch, which is caused by fear of lending, not an unwillingness to borrow.

How much should the Fed ease on September 18?

As a general rule (at least a general McTeer rule), policy changes should be front loaded, and can taper off later.  The FOMC should cut the Fed-funds target rate by 50 basis points, and perhaps cut the discount rate by 25 to 50 basis points as well.  When things start looking up, they can move to 25 basis point cuts if they wish.

One reason for a frontloading policy in general is that, early on, you know what is needed; so there's little reason to be cautious.  Later on, a time will come when there is less certainty whether more is needed-when you must worry about a bridge too far.  At that point, smaller changes are appropriate so any mistake will be a smaller mistake.  Remember:  bold early; more cautions later.

Of course, aside from the general frontloading rule, which calls for boldness now, we have an emergency situation that also requires boldness.  We have a credit crunch caused by fear of lending. Under present circumstances, shock and awe is warranted.