Fed May Couple Cut With Measures to Increase Credit

Fed May Couple Cut With Measures to Increase Credit (Update2)

By Scott Lanman

Dec. 5 (Bloomberg) -- Federal Reserve officials, who are forecast to lower their main interest rate next week, are signaling that they are looking for additional ways to increase credit to companies and consumers.

The Fed may lower the discount rate -- what it charges banks for short-term direct loans -- by a quarter-point more than the benchmark rate after Vice Chairman Donald Kohn and San Francisco Fed President Janet Yellen publicly expressed frustration that previous rate cuts haven't encouraged banks to lend to one another.

Such a move would narrow the gap between the two rates -- normally 1 percentage point -- to a quarter-point. Economists said that may spur lending by easing the stigma of borrowing at the discount rate, letting firms claim they are taking advantage of a better deal.

``The Fed has to re-liquefy the markets to reduce the risk of a financial accident,'' said Lou Crandall, who used to work at the New York Fed and is now chief economist at Wrightson ICAP LLC, a Jersey City, New Jersey-based research firm that focuses on government debt.

Policy makers are struggling to contain a crisis of confidence among banks that sent the cost of three-month loans between lenders to the highest in seven years. Failure to head off a credit crunch may send the economy into its first recession since 2001, economists said.

Rate Forecasts

Crandall predicted the Fed will lower the discount rate by half a point, to 4.5 percent, and the main federal funds rate target by a quarter-point to 4.25 percent when it meets Dec. 11.

Bill Gross, manager of the world's biggest bond fund at Pacific Investment Management Co., wrote on his Web site the Fed may have to lower the rate below 3 percent next year to ``restart a near recessionary economy.'' His forecasts have a checkered history: he said in May 2005 the Fed would stop raising rates at 3.25 percent. By June 2006, the benchmark was 5.25 percent.

Futures prices indicate a two-thirds chance of a quarter- point move in the federal funds rate next week and a one-third chance of a half-point reduction. That compares with about a 50- 50 probability yesterday, before today's ADP Employer Services report showed companies added more than triple the number of jobs economists had forecast for November.

`Frustrated' Fed

``The Fed is frustrated they can't get anyone to come to the discount window,'' said Ethan Harris, chief U.S. economist at Lehman Brothers Holdings Inc., and a former head of domestic economic research at the New York Fed. ``If the Fed lowers the discount rate closer to the funds rate, banks can represent their decision as merely borrowing at the best place to get money, rather than an act of desperation.''

The Fed has other options to ease the funding crunch besides reducing the penalty for discount-window borrowing.

One possibility is tripling the length of discount-window financing to 90 days from 30, said Stephen Cecchetti, a former research director at the New York Fed. The central bank, in its Aug. 17 decision to lower the discount rate a half-point to 5.75 percent, also extended the terms to allow 30-day financing instead of just overnight loans.

``Lengthening the term of the lending would really be more important,'' said Cecchetti, now a professor at Brandeis University in Waltham, Massachusetts.

Year-End Crush

Demand for cash typically rises at the end of the year as banks conserve funds to buttress balance sheets before closing their books. This year, that has combined with concerns about mounting losses on securities linked to mortgages at risk of default to cause borrowing costs to climb.

One gauge watched by the Fed shows rates at their highest relative to the Fed's benchmark since 2000.

The three-month dollar London Interbank Offered Rate, a benchmark for corporate borrowing, climbed to 65 basis points more than the Fed's target federal-funds rate yesterday. Excluding Sept. 18, when the Fed lowered its rate by half a point, that's the widest spread since May 2000, a period that includes the last U.S. recession in 2001.

Policy makers first addressed the August credit collapse by injecting funds into money markets, then lowering the discount rate. The Federal Open Market Committee followed up the next two months by cutting both rates by 0.75 percentage point.

Rate Gap

Officials sought to enhance the attractiveness of the discount window by reducing the gap with the federal funds rate and widening the collateral accepted for loans. While borrowing rose to $2.9 billion in the week ended Sept. 12, the highest since 2001, it has since fallen back, to $7 million last week.

The ``discount window has not been as used, or been as helpful at addressing liquidity issues, as I would have hoped,'' San Francisco Fed President Janet Yellen said Dec. 3 in Seattle. Along with other officials, she noted a ``stigma'' about banks tapping the loans.

Yellen, a former Fed governor and chairman of President Bill Clinton's Council of Economic Advisers, added that she's ``open to constructive suggestions'' on enhancing liquidity.

Kohn said in New York on Nov. 28 that the Fed needs ``to give some thought'' to how ``liquidity facilities can remain effective when financial markets are under stress.''

The Fed could draw on its 1999 template, when it addressed potential money shortages during the 2000 computer-system changeover, Cecchetti said. The Fed sold options on almost $500 billion of repurchase agreements for standby financing. None were exercised.

Also, officials at the Fed's Board of Governors and regional banks prepared a paper in 2000 identifying ``alternative instruments'' for policy. One possibility is to lend to ``strong financial institutions'' at a rate equal to the federal funds rate, the document says.

BLOOMBERG