Fed's auction fails to reduce premiums

The Federal Reserve's new twice-monthly loan auctions have failed to reduce banks' borrowing costs since officials introduced them in December, Stanford University economist John Taylor said.

There is "no empirical evidence" the Term Auction Facility has reduced the premium that banks charge each other to lend cash for three months, Taylor, author of a monetary-policy formula cited as a benchmark by analysts, wrote in a research paper. San Francisco Fed economist John Williams co-wrote the study, which was posted on the San Francisco Fed's website on Wednesday.

The paper is one of the first assessments of the Fed's efforts to inject liquidity into the US financial system as policy makers try to stem what the International Monetary Fund termed the worst credit shock since the Great Depression. Chairman Ben S. Bernanke followed up the TAF last month by starting to lend funds directly to investment banks.

"I'm not ready to say that they should abandon it, but I do think that one of its stated purposes has not been borne out," Taylor said in a telephone interview on Wednesday. "That's an important finding."

Working group

The group, which includes the heads of the Fed, Treasury, Commodity Futures Trading Commission and Securities & Exchange Commission, called for stronger management of capital and financial risks.

Officials were frustrated last year when commercial banks limited their use of direct loans from the Fed even as their funding costs soared. Policy makers blamed a "stigma" associated with asking the central bank for money.

In December, the central bank introduced the TAF, which allows the Fed to determine the amount of funds it wants to add to the banking system. The auctions have typically been for 28-day funds. The Fed increased the size of the operations last month to $50 billion each, from $30 billion previously.

"We show that increased counterparty risk between banks contributed to the rise in spreads and find no empirical evidence that the TAF has reduced spreads," Taylor and Williams wrote in the paper. "We do not mean to imply that the Federal Reserve did not have other goals in creating the TAF, including reducing the stigma associated with discount-window borrowing by banks."

Fed spokesman David Skidmore in Washington declined to comment.

The difference between the rate banks charge for three- month dollar loans relative to the overnight indexed swap rate, a measure of what traders expect for the Fed's benchmark rate, was 64.14 basis points on Wednesday, compared with an average of 34.24 basis points over the past year. The so-called Libor-OIS spread averaged less than 10 basis points in the first half of 2007.

Fed officials have said they aren't using the TAF operations to increase total cash in the system. Instead, the goal is to encourage banks to lend to each other over periods extending beyond overnight.

Because the TAF operations don't provide net new funds, and don't have a bearing on traders' expectations for the Fed's interest-rate decisions, theory suggests they "will not affect the spread".

"Our simple econometric tests support both of those implications of our model," Taylor and Williams wrote.

Treasury role

Taylor, 61, served as the Treasury Department's top international official from 2001 to 2005. Williams, a senior vice-president at the San Francisco Fed, has worked as a Fed economist since 1994.

The Fed announced the TAF after lowering its benchmark interest rate by 1 percentage point from September to December, a pace that some investors and economists criticized as too slow.

Agencies

(China Daily 04/11/2008 page17)