The Sub Prime Crisis: The Fed’s impact on money markets

(Ref: Wall Street Journal, August 21, Financial Times August 21)

About a week back (August 17th) the Fed reduced the discount rate, the interest rate at which the Fed provides funds to banks, as a lender of last resort. The Federal funds rate, the interest rate at which banks led to each other, has still not been cut. But the stock markets, in anticipation of such a cut, have bounced back a little. In contrast, the money markets, for whom the message was intended, have reacted in a negative way. Money market investors have retreated to safety, investing heavily in short term US government debt. On August 20, the yield on the one month treasury bills fell to 1.34% (about 160 basis points) while that on three month treasury bills fell to 2.51% (123 basis points). This retreat to safety is a clear indication that risk aversion has seized the markets. There is now speculation that the Fed will cut the Federal Funds rate on September 18, the date of the next policy meeting. Meanwhile, yesterday (August 20), major central banks continued to pump funds into money markets. The ECB has so far injected liquidity to the tune of Euro 95 billion on August 9, Euro 61 billion in Aug 10, Euro 47.7 billion on August 13, and Euro 7.7 billion on August 14. Yesterday (August 20) the Fed pumped in $3.5 billion of overnight funds while the Bank of Japan added $8.76 billion to short term money markets.