Fed Discount Rate Cut: What They Are Doing

The Fed cut the discount rate today.  If you’re just getting around to hearing the news, the announcement is here.

This is NOT an easing of monetary policy.  This is a provision of liquidity.  I expect that the Fed followed the pattern of the Penn Central Crisis.  (Read "Adam Smith’s" account of this in The Money Game; it’s hilarious and accurate both.)  When the Penn Central railroad declared bankruptcy, the commercial paper market panicked.  Federal Reserve officers got on the telephone to all of the country’s top bank executives and said, "If someone who might be credit worthy walks past your bank, lend them some money."

The Fed’s goal today is to ensure that credit-worthy enterprises get credit.  It’s not a bail-out move, or a general easing, but an action targeted at stopping a contagion, in which the subprime market’s problems spread over to the healthy side of the economy.  Think of the subprime house as having a big "Quarantine" sign on it.

Outlook: these are scary times, no doubt about it.  But so long as the Fed succeeds in limiting the financial crisis to the sectors that deserve a crisis, the economy will be OK.  I expect the Fed to succeed.  (I am also keeping my fingers crossed.)