The Federal Reserve raises the discount rate in a surprise move: what does it really mean?

19th February 2010 by Shaun Richards

Tonight in a move where the timing more rather than the reality caught markets and analysts by surprise the Federal Open Market Committee (America’s Central Bank) raised its discount rate by 0.25% to 0.75%. This is the rate that it charges to banks for direct loans. It made this move after US financial markets closed tonight (Thursday) and the move takes place from tomorrow 19th February 2010. It made a statement with the news from which I shall quote some excerpts below. 

The Federal Open Market Committee’s Statement 

these changes are intended as a further normalization of the Federal Reserve’s lending facilities. The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy, which remains about as it was at the January meeting of the Federal Open Market Committee (FOMC).  

The changes to the discount window facilities include Board approval of requests by the boards of directors of the 12 Federal Reserve Banks to increase the primary credit rate (generally referred to as the discount rate) from 1/2 percent to 3/4 percent. This action is effective on February 19. 

In addition, the Board announced that, effective on March 18, the typical maximum maturity for primary credit loans will be shortened to overnight.Primary credit is provided by Reserve Banks on a fully secured basis to depository institutions that are in generally sound condition as a backup source of funds. Finally, the Board announced that it had raised the minimum bid rate for the Term Auction Facility (TAF) by 1/4 percentage point to 1/2 percent. The final TAF auction will be on March 8, 2010. 

  

What do these moves mean? 

Slightly confusingly the Fed refers to the discount rate as a primary credit rate. However when the crisis started it reduced the margin from one per cent to a half of one percent over the Fed’s target rate for the Federal Funds rate. In essence it was improving the terms on which it would lend to banks and financial institutions by letting them have the money more cheaply. This move was made on the 17th August 2007 as the credit crunch began to bite. 

At the same time the Fed lengthened the time period over which it would lend such money from overnight to 30 days. Not many people understand that normally central banks only control overnight interest rates and these ripple out into the market. As at the date mentioned we were most definitely not in normal times the Fed responded by lengthening the term it would lend over. This was to help the banking system but also has the effect of helping to enforce its own policy and rates (one of the issues of the credit crunch was market rates diverging from official ones). 

The Term Auction Facility (TAF) was introduced to help improve the access of depositary institutions to term funding. It started on December 12 th 2007 (partly because the previous moves discussed above were not working as hoped). The TAF was modified in March 2008 so its maximum term was 90 days. However since June 2009 the Fed has been winding it down and its last auction will be on March 8th. 

What is the FOMCs stated intention? 

The increase in the spread and reduction in maximum maturity will encourage depository institutions to rely on private funding markets for short-term credit and to use the Federal Reserve’s primary credit facility only as a backup source of funds. The Federal Reserve will assess over time whether further increases in the spread are appropriate in view of experience with the 1/2 percentage point spread 

In essence the Fed is moving its policies back to something much more like what they were before the credit crunch and this is what they mean by the word “normalisation.” 

Market Reaction 

After rallying some 80 points in Dow Jones terms during the trading day the American stock market promptly lost it after this news came out. The US $ strengthened against the Euro and Treasury Bonds fell slightly. We will have to wait until markets open on Friday for a full reaction. 

What does this really mean? 

There are elements of a purely technical change here and the Fed has a go at reinforcing this in its statement by saying the outlook is “about as it was at the January meeting of the Federal Open Market Committee.” But if that is true why did they not make the change then? There was a mention of this subject in the minutes of the January meeting which were released on Wednesday. So it is not impossible that the Fed did not fully anticipate reaction to revealing this and decided to get on with it but this still does not fully answer the question of why it did not move at the last meeting. 

However I feel that with the US economy showing signs of strengthening for example producer prices were higher than expected today mostly due to higher fuel prices then this looks like it is the beginning of the Fed’s exit policy from the extraordinary policy stimulus it has used to support the American economy. 

If the Fed has moved because of higher than expected inflation figures perhaps this might give a hint to our own Monetary Policy Committee…..If you have had problems logging onto my blog in the last 12 hours or so I would like to apologise as WordPress has had some problems.

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