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Fed Lowers Fed Funds and Discount Rates

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Hoping to “help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time,” the Federal Reserve Open Market Committee lowered the Fed Funds rate to a target of 4.5%, and the Discount rate to 5%, a 25-basis point drop for each rate, according to an October 31 announcement from the Federal Reserve Board of Governors.

The vote to lower the Discount rate was unanimous, but the vote to lower the Fed Funds rate was not, with Thomas M. Hoenig, who wanted to keep the Fed Funds rate where it had been, voting against the cut.

The Fed’s move to cut 25 basis points was widely anticipated as the markets and the U.S. economy face ongoing instability. Although the Fed’s statement says “economic growth was solid, and strains in financial markets have eased somewhat on balance,” in the past week alone, the markets have seen lowered ratings from the major ratings services on billions of dollars worth of CDO and CMO paper, and a write-down by Merrill Lynch of $7.9 billion in its portfolio of CDO-related securities, which resulted in the immediate retirement on October 30–without naming a permanent successor–of the firm’s CEO and Chairman, Stan O’Neal.

Then there is the ongoing saga of the attempt by Wall Street banks to find players brave enough to participate in the Fed-supported $80 billion fund that is being put together by Citigroup, JPMorgan Chase, and Bank of America. The fund is supposed to bail out Structured Investment Vehicles (SIVs), effectively holding vehicles for mortgage and other structured securities, which fund themselves in the commercial paper markets but face a big problem as their current commercial paper matures: Because no one knows how far, how deep, and how long the mortgage and credit crisis will last, institutional buyers don’t want to buy new commercial paper backed by the SIVs, and as a bulge of SIV commercial paper matures over the next few months, SIVs could have to sell already depressed long-term securities to pay off the short-term debt that is maturing.


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