In a note to clients this afternoon, Merrill Lynch economist David Rosenberg suggests that the Federal Reserve's cut in the discount rate this morning may be an effort to identify troubled lenders. The Fed has two ways of pumping money into the economy. 1) Changing the federal funds rate on the money that banks loan each other overnight. 2) Changing the discount rate on the money the Fed loans to banks directly. The first method is indirect. The Fed manipulates the overnight market as a third party and has no idea who is borrowing and who is lending. The second method is face-to-face. You can't belly up to the discount bar without getting carded and identified by the New York Fed.

By cutting the discount rate and not the federal funds rate, Rosenberg suggests, the Fed may be coaxing troubled banks to come to papa. The fed funds rate is still lower than the discount rate, but terms for discount-window borrowing may be easier, especially with the 30-day feature installed this morning. Rosenberg:

Clearly the Fed is trying to entice institutions that cannot access funds in the marketplace to borrow from the discount window - maybe in order to gain information as to who is really in trouble from a funding standpoint.

Needless to say, we have never seen the Fed cut the discount rate this much without a change in the funds rate, so clearly it is trying to send a message to the markets without having to imply that it is panicking. Talk about walking a fine line. Cutting the funds rate would have been a really big deal since it would be an admission that the Fed is now extremely nervous about the economic outlook; and for the markets this would have suggested a bolder move - that the Fed is now willing to supply liquidity on a more permanent basis. Note that in contrast to what some believe, the Fed has not lowered the credit standards on collateral they will accept, in other words the collateral base has NOT been expanded. However, as is always the case, the Fed by definition accepts a wider base of collateral at the discount window than it does in its repo operations.

We think that today's discount rate cut is mostly symbolic in nature (though companies such as Countrywide through the bank counterparts are allowed to borrow at the discount window). The real message is in the press statement today which is vastly different from what we saw last week at the post-meeting statement. Not a word about inflation this time - the Fed said that it is "monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets".