Counting the instruments

If you are following monetary policy in these testing times, and especially if you find recent Fed actions (and the markets' reaction to them) puzzling, two posts by James Hamilton at Econbrowser will help. Not that they clear things up, so much. But they make being puzzled an easier position to defend. First, James ponders the "surprise" cut of only 25 basis point in the fed funds rate.

Was Wall Street really expecting a 50-basis-point cut? Looking at
fed funds futures or options, you might have thought this was a
significant possibility. For example, the graph below is the interest
rate implied by the January fed funds futures contract, which
historically has proven to be an excellent predictor
of the monthly average fed funds rate. This had been trading at 4.18%
prior to the meeting. Since the FOMC is not scheduled to meet again
until January 29/30, one might have read this as implying a 30% chance
of having seen a 50-basis-point cut from yesterday's meeting:

(0.7)(4.25) + (0.3)(4.0) = 4.18

Implied interest rate on January 30-day fed funds futures contract.  Data source:

But here's the curious thing: as of this writing, the price of that
contract still has not budged more than half a basis point from where
it stood at the close of trading last Friday. Fed funds futures traders
seem not to have been surprised in the least by the outcome of
Tuesday's meeting.

So why did the market drop? "Beats me," he concludes. James next looks at the Fed's new "term auction facility":

Evidently there are those who entertain the hope that the Fed could
find two separate tools to achieve two separate ends. The first tool--
the traditional instrument of monetary policy-- is to adjust the total
quantity of reserves available to the banking system so as to achieve a
particular target value for the fed funds rate, the rate at which one
bank lends to another overnight. When one describes a traditional
monetary policy action as "providing liquidity," this is what we are

But there appears to be a widespread belief that the Fed needs a
second tool in order to achieve a second policy objective, which is
somehow to eliminate the gridlock in financial institutions resulting
from huge holdings of assets that no one seems willing to buy. Perhaps,
the thinking seems to go, adjusting the spread between the discount
rate and the fed funds rate could be a tool to accomplish this.

I am inferring that the Fed itself may also have been musing along these lines, in that it today announced creation of a term auction facility.
The basic idea is that the Fed will specify a certain maximum amount
that it would like banks to borrow. It intends to lend up to $20
billion for a 28-day term on Monday, and lend up to an additional $20
billion for a 35-day period on December 20. Potential borrowers will
bid an interest rate to receive this loan, with I presume each $20
billion going to the highest bidders. Banks must also provide
collateral for these loans.

The objective is clearly not just to get $40 billion more in
reserves into the banking system next week-- an open market operation
could accomplish that just fine. The objective must be to get the
reserves into the hands of those particular banks that want them most...

The other thing the facility accomplishes is allow the Fed to accept
lower-quality collateral from borrowers than its rules require for open
market operations conducted through repurchase agreements. If there is
an effect of the facility, I would think that this would be the
mechanism. What may matter is not the reserves put in the system, nor
who gets those reserves, but the troublesome assets temporarily taken
off some institutions' balance sheets.

Isn't that a "bail-out"?

The Fed's initiative was announced in concert with other big central banks, which also took steps to boost liquidity. As the FT reported, however, short-term interest rates hardly budged. The markets don't yet know what to make of it all.