Friday, February 19, 2010

Regarding the Discount Rate Increase ...

Yesterday -- after the markets closed -- the Federal Reserve increased the discount rate.

There are a few points that should be mentioned regarding this development.

1.) This is the rate the Fed charges banks who borrow short-term from the Fed. All the Fed is doing is putting the discount window back on normal footing. That's it. And to that end:
While borrowing by banks from the Fed’s discount window has already fallen to more historically normal levels from its peak in October 2008, many small and medium-size businesses still find it difficult to obtain loans, a major concern of the Obama administration and Congress.

Randall S. Kroszner, an economist at the Booth School of Business at the University of Chicago and a former Fed governor, said after the announcement: “This is a technical change that makes sense as a precondition for other changes, but is not a precursor of short-term change.”

And consider these points from the
WSJ's Economic Blog:

* To normalize capital markets, the Fed has to eliminate the distortions quantitative ease create and, to this end, raising the discount rate is the first of many necessary steps. The last step will be directly raising short-term markets rates, be it the Fed funds rate or the IOER [interest rate on excess reserves]. We still don’t know what will guide the Fed to do how much and when, and that is a problem. Today’s move was designed to take free arbitrage off the table rather than be any statement about the state of the economy other than that the financial system is stable enough to begin standing on its own. A stable financial system is necessary for the economy to grow but not sufficient. The minutes of the January FOMC meeting were a sober assessment of the economy giving little sense that prospects are for anything more than stable growth around 2% to 3% despite record monetary and fiscal stimulus. Given this outlook, a pace of unwind as accelerated as some FOMC members seem to want is very much unlikely. – Steve Blitz, Majestic Research

* While the increase in the discount rate came a bit earlier than we thought, it was clearly heralded by Chairman Bernanke in his testimony on February 10. … This step, in combination with the closure of most short-term liquidity programs earlier this month “is intended as a further normalization of the Fed’s lending facilities” in light of continued improvement in financial market conditions. We too would like to emphasize that the discount rate is a tool for addressing financial system stress, while the fed funds rate is a tool for addressing macroeconomic stability. … Just like easing the terms for discount window lending programs was the first response of the Fed to the crisis (in August 2007), its removal is now the first part of the exit strategy. – Harm Bandholz, UniCredit Research

2.) Ask yourself a simple question: when should a central bank raise interest rates? When there is no need to stimulate the economy. That makes this a good sign. If the Fed were worried about the pace of the recovery, they wouldn't even think about raising the discount rate. The fact they are thinking about it indicates they see the economy in a more positive light