U.S. Federal Reserve Expands Terms and Conditions for Special Liquidity Facilities on July 30, 2008

Total credit available under the TAF will remain unchanged at $150 billion, but the average maturity of the funds borrowed will increase. The TSLF (term securities lending facility) will be expanded from $200 billion to $250 billion, by offering auctions of options to borrow from the TSFL facility of up to $50 billion. The European Central Bank and the Swiss National Bank will also be making parallel extensions of the maturity structure of their special liquidity operations, and the Fed's swap line with the European Central Bank will be increased. This latest set of bells and whistles represents the fourth major expansion of the programs since they were introduced.

Global Insight reckons that the previous facilities were equivalent to a reduction in effective short-term borrowing costs of about 25–30 basis points, and this latest expansion would bump this effective reduction in borrowing costs further—perhaps by an additional 10–15 basis points—depending on market conditions.

The programs are designed to combat systemic risks to the financial system related to short-term funding pressures—pressures that can be significantly exaggerated by contagion and speculative bandwagon effects. These pressures re-emerged at the end of June and in early July—the fourth episode of severe pressures in the financial markets since the crisis erupted in U.S. and European financial markets in August 2007.

The further extension of the facilities reflects concerns at the Federal Reserve that ongoing downward cyclical pressures in the U.S. housing market and the U.S. economy are feeding back onto the financial system, leading to significant unanticipated write-offs of capital, which in turn is feeding back to restrict credit conditions and further slow the growth of the economy. These negative feedback loops have been in play since the financial crisis erupted in August 2007, but entered a new danger zone in recent weeks as several financial entities failed, financial sector equities spiraled downward, and the re-capitalization efforts of major financial players encountered significant obstacles in the marketplace.

The expansion of the facilities is a signal that the Fed is very concerned about the impact of these negative feedback loops on the stability of the financial system and the health of the economy. At the same time, the Fed does not want to send a signal to the markets that it is not prepared to deal with the possible inflation threat related to the ramp up in energy prices over the past year. Ramping up the liquidity facilities, while at the same time keeping benchmark borrowing rates steady, looks like the best strategy for dealing with these twin threats at this particular juncture.

Clearly, the financial markets and the economy have entered a new danger zone, with increased risk of a major negative event and a hard landing for the economy. But the good news is that the Fed does have more arrows in its quiver beyond the adjustment of the federal funds rate—and is not hesitating to use them and expand their effectiveness as necessary.