LIQUIDITY ANALYSIS. GOVERNOR MISHKIN ON THE TERM AUCTION FACILITY
. Frederic S. Mishkin: "The Federal Reserve's Tools for Responding to Financial Disruptions", February 15

Federal Reserve Board governor Frederic Mishkin does a useful job here. The main point is the detailed discussion of the Term Auction Facility, announced on December 12. This new instrument, described as one of the "tools for supporting market liquidity", is aimed at providing credit to eligible borrowers for a term "substantially longer than overnight":

Despite the Federal Reserve's provision of liquidity through open market operations and the discount window, strains in term funding markets persisted and became particularly elevated in early December in response to year-end pressures. The magnitude of these strains can be gauged using the spread between Libor--that is, the London interbank offered rate--and the overnight indexed swap (OIS) rate at the same maturity, because the OIS rate reflects the average overnight interbank rate expected over that maturity but is not subject to pressures associated with credit and liquidity risks to the same degree as Libor.

As shown in chart 2, the one-month and three-month Libor-OIS spreads were at low levels through the month of July but increased markedly in August and early September at the onset of the financial market turmoil.6 The one-month spread declined during the fall but rose sharply again toward the end of the year. In association with these wider spreads, liquidity in term bank funding markets deteriorated substantially.

To address these pressures, the Federal Reserve introduced a new policy tool called the Term Auction Facility (TAF).7 With this tool, the Federal Reserve auctions a pre-announced quantity of credit to eligible borrowers for a term substantially longer than overnight; thus far, each auction has involved a term of one month. As with primary credit, a depository institution is eligible to participate in a TAF auction if the bank is judged to be in generally sound financial condition, and a wide variety of collateral can be used to secure the loan. The minimum bid rate for each auction is established at the OIS rate corresponding to the maturity of the credit being auctioned.

The introduction of the TAF was announced on December 12 in conjunction with related announcements by the Bank of Canada, the Bank of England, the European Central Bank, and the Swiss National Bank (Board of Governors, 2007c).8 The first two auctions were held on December 17 and 20, for amounts of $20 billion each, and were very well subscribed: A large number of banks participated in each auction, and the total value of bids was about three times as large as the amount of credit auctioned. The resulting interest rate in both cases was about 50 basis points above the minimum bid rate but well below the one-month Libor rate prevailing in financial markets at that time. In recent weeks, the Federal Reserve has conducted three more auctions (most recently, last Monday) for amounts of $30 billion each. The spread over the minimum bid rate was about 7 basis points for the January 14 auction, 2 basis points for the January 28 auction, and 15 basis points for the February 11 auction; these spreads were much lower than in December, apparently reflecting some subsequent easing in the pressures on banks' access to term funding.

The TAF appears to have been quite successful in overcoming the two problems with conventional discount window lending. Thus far, the TAF appears to have been largely free of the stigma associated with borrowing at the discount window, as indicated by the large number of bidders and the total value of bids submitted.9 Furthermore, because the Federal Reserve was able to predetermine the amounts to be auctioned, the open market desk has faced minimal uncertainty about the effects of the operation on bank reserves; hence, the TAF has not hampered the Federal Reserve's ability to keep the effective federal funds rate close to its target.

Isolating the impact of the TAF on financial markets is not easy, particularly given other recent market developments and the evolution of expectations regarding the federal funds rate. Nonetheless, the interest rates in term markets provide some evidence that the TAF may have had significant beneficial effects on financial markets. As can be seen in chart 2, term funding rates have dropped substantially relative to OIS rates: The one-month spread exceeded 100 basis points in early December but has dropped below 30 basis points in recent weeks--though still above the low level that prevailed before the onset of the financial disruption last August.