Can someone discuss how lowering the discount rate stimulates the economy? I understand the fed funds rate cut logic, but was wondering about what sequence of events encourages economic growth w/ respect to the discount rate. Thanks!
spurs on borrowing
Lower interest rate on debt (for companies) => Lower WACC => More projects beat the WACC, and are therefore undertaken, that translates into Capex, Salaries, and all other kind of purchases required by that project. Lower interest rates on costomers => Makes credit cheaper (if not easier), that should encurage cusomers to go to debt up to their eyeball in order to spend, spend, spend. Alternativelly, customers who are already in debt up to their eyeball can postpone bankruptcy, and that is positive for banks and financial institutions.
lower rate on debt lowers the cost of equity (all else equal, risk premium remains the same, but risk free decreases). Lower cost of equity, spurs company valuation upwards.
as mentioned, the basic reason is that it increases investment at the margins, which should improve productivity, or at least output. The most direct effect is that it lowers average borrowing costs, so companies that were holding out to invest in equipment and stuff now find it cheaper to acquire because the interest cost is lower. As I said, this happens at the margins, so its that next thing on the menu (the one that didnt make the cut last time) that gets funded. There is also an indirect on equities, which is that the hurdle rate for equity investments drops. If the required return is beta*(equity risk premium) +(risk free rate), then the rfr just went down but the erp stayed the same. As a result, projected cash flows are discounted at a lower rate and asset values rise. This raises stock prices, and also makes it less expensive to raise equity capital .
Isn’t the discount rate the rate at which banks borrow directly from the fed if there is no one left to borrow from (therefore a higher rate)? I guess I shoud rephrase my question- how does economic stimulation from a cut in the discount rate compare/contrast to fed funds rate cut?
strikershank Wrote: ------------------------------------------------------- > lower rate on debt lowers the cost of equity (all > else equal, risk premium remains the same, but > risk free decreases). > > Lower cost of equity, spurs company valuation > upwards. The original question was about the economy, not about the stock market
clos83 Wrote: ------------------------------------------------------- > Isn’t the discount rate the rate at which banks > borrow directly from the fed if there is no one > left to borrow from (therefore a higher rate)? I > guess I shoud rephrase my question- how does > economic stimulation from a cut in the discount > rate compare/contrast to fed funds rate cut? good point. I was a little sloppy, since the discount window is not quite the same as the fed funds rate. However the result is pretty similar, except that what happens us that the expected rate on high quality bonds drops (banks that borrow pass on at least some of the discount) and unless there is a compelling reason that equities should become more risky, the premium of equities over bonds stays the same, so the total discounting rate on equities still drops, with said effects.
In this case you should think of the discount rate as a liquidity source of last resort. As credit markets tightened over the last several months banks suddenly became acutely aware of the massive contingent liabilities that were building up on their balance sheets. Starting with subprime, securitization markets across asset classes began to seize up. RMBS, CDOs, CLOs, leveraged loans, ABCP, you name it, suddenly the distribution model that was such a huge money-maker for the street ground to a halt. When this happens, banks become nervous about how bad it can get and start hoarding their liquidity. They refuse to lend to one another as they are unsure about what might be looming around the corner, so they hoard any excess funds they might have on hand. Injecting liquidity via open market ops only does so much here, as ultimately the fed funds market is still an inter-bank one and is dependent on banks willingness (along with ability) to lend to one another. The discount window, however, is a direct bank-to-Fed market. They never say no (within the guidelines of acceptable collateral). Lowering the penalty spread at least makes the economics of discount borrowing less painful. The idea is that banks should be less concerned with hoarding liquidity if there is a viable backstop source of funding, and therefore more willing to allow the newly increased supply of funds to spread throughout the system. Even if assets held in ABCP conduits do come back on balance sheet, the bank could just take them to the window and fund them at sub-libor levels. Of course psychologically bankers grew up thinking borrowing through the window was a sign of weakness, and it is hard to shake that stigma. From there, the effects of the increased supply of credit on the economy were well-explained by the other posters. But that is the mechanics within the banking system.
Doesnt the discount window require Treasuries or Agencies (FM, GM) collateral? Where does that leave banks with significant AB assets (or derivatives such as CDOs)? Setting discount rate at 0% wouldn’t help them would it?
DarienHacker Wrote: ------------------------------------------------------- > Doesnt the discount window require Treasuries or > Agencies (FM, GM) collateral? Where does that > leave banks with significant AB assets (or > derivatives such as CDOs)? Setting discount rate > at 0% wouldn’t help them would it? Back a month or two ago, the fed said that it would accept crap (asset backed securities) as collateral. Some banks (including large banks - Citi comes to my mind) took advantage of the discount window. The other reason why banks don’t run at the discount window is that traditionally, banks only went there when they were unable to raise cash anywhere else. Hence, there is the stigma that by going at the discount window, the regulators would closely watch the bank’s operations, and banks don’t want that.
if I understand the question right, lowering the rate is the same way as saying that the BoC will buy back bonds at bigger discounts - in other words, they will pay more for bonds which means there will be more money in the pockets of banks and it trickles down from there (banks lend out this money). the effect is that investment costs are lower, which creates good incentives for people to make investments (real investments in assets, technology, etc.) which increases employment overall. but this also creates inflation.
olivier Wrote: > Back a month or two ago, the fed said that it > would accept crap (asset backed securities) as > collateral. Is this at all related to that COLOSTOMYBAGS thing?
mikeintoronto Wrote: ------------------------------------------------------- > but this also creates inflation. Well, perhaps according to a school (or a few schools) of thought. But the one thing we know for certain about inflation is that no one knows its causes.
its the good old argument about what causes inflation! I’m convinced though that monetary policy causes it. I can’t contemplate what else could lift overall prices in an economy… why isn’t the austrian/classical school more dominant?
Big Nodge- thanks for your commentary, exactly what I was wondering about, you also answered what I was going to ask next about collateral.