The Federal Reserve Raises Its Discount Rate
by Charles Lemos, Thu Feb 18, 2010 at 10:07:11 PM EST
The Federal Reserve, the Central Bank of the United States, has raised its discount rate by a quarter of a percentage point, to 0.75 percent from 0.50 percent, effective tomorrow Friday, February 19, 2010. The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility - the discount window. From the Federal Reserve's press release:
The Federal Reserve Board on Thursday announced that in light of continued improvement in financial market conditions it had unanimously approved several modifications to the terms of its discount window lending programs.
Like the closure of a number of extraordinary credit programs earlier this month, 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). At that meeting, the Committee left its target range for the federal funds rate at 0 to 1/4 percent and said it anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.
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.
Cutting through the noise, the move by the Fed which had been expected signals the early stage of the Fed's "exit strategy."It is an opening act and a test of the financial markets.
Just over a week ago, Ben Bernanke, the Federal Reserve Chairman, had outlined the likely path the Fed would take to tighten credit once the economy has recovered enough in prepared remarks that had been intended for delivery at a House Financial Services Committee hearing that was canceled due to the inclement weather in Washington.
In testimony prepared for a House Financial Services Committee hearing that was called off because of a blizzard in Washington, Mr. Bernanke said that another interest rate might for a time replace the federal-funds rate as the main policy tool. That's the rate the Fed pays to banks on excess reserves they leave at the central bank.
Mr. Bernanke said that though the economy needed support from monetary policy, the Fed would "at some point" increase short-term rates and drain some of the money it had pumped into the economy during the recession. He gave no hint that such a move was imminent.
As part of its plans to wind down emergency liquidity measures, the Fed may "before long" increase the difference between the discount rate and the federal-funds rate, a Fed-influenced rate at which banks lend to each other overnight, he said. The spread between the rates is a quarter percentage point; before the crisis, it was a full point.
Mr. Bernanke's speech was designed to outline the Fed's strategy for withdrawing its extraordinary support for the economy, which has brought the federal-funds rate near zero and led the Fed to buy more than $1 trillion worth of U.S. Treasury and mortgage-backed securities. He said the sequencing and tools the Fed would use to tighten policy would depend on how the economic recovery develops.
The Fed chairman said he didn't currently anticipate the Fed would sell any of its holdings of long-term U.S. Treasurys or mortgage-backed securities "in the near term," and probably not "until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery." But over time, he said, "the Federal Reserve anticipates that its balance sheet will shrink toward more historically normal levels and that most or all of its security holdings will be Treasury securities."
In short, the move by the Fed is a technical change looking to normalize the discount rate to more historical levels as it prepares to sop up the excess liquidity that it pumped into the banking sector to keep them and the economy afloat over the last two years. And as the New York Times notes it is the start of a delicate dance for the Federal Reserve.