Fisher Investments Editorial Staff
US Economy, Monetary Policy

A Fed Surprise

By, 02/22/2010

Story Highlights:

  • The Fed announced late Thursday steps to normalize monetary policy, including raising the discount window rate to 75 bps from 50 bps, effective Friday.
  • The Fed widely broadcast these moves are the early stages in the normalization of credit policy—not surprising since financial institutions are on much firmer footing now.
  • These changes are largely symbolic, minor technical changes—not a signal the Fed's moving away from an accommodative stance.


After the stock market closed Thursday, the Fed announced it's moving to normalize monetary policy a bit, including raising the discount rate 1/4 percent from 0.50% to 0.75%. The move initially caught investors by surprise, causing some to fear a new monetary tightening cycle was afoot and sending stocks lower in after-hours trading. But by the close of trading Friday, calmer heads prevailed, and US stocks finished the day higher—the fifth consecutive day of gains for the S&P 500.

The discount rate is the lesser of the Fed's policy rates. The more influential and widely followed federal funds target rate hasn't budged since it was dropped to a range of 0%-0.25% in December 2008. Banks in need of short-term reserves typically transact with other banks in the Fed funds market. But troubled banks can be shut out if their financial situation is dire enough. Those firms can then turn to the Fed's "discount window"—no longer an actual window, but a facility enabling the Fed to loan money directly to banks at the discount rate.

Since 2003, the discount rate has been set 1% above the federal funds rate, creating an added cost to borrow directly from the Fed. But the disincentive wasn't only financial. Borrowing from the discount window carried a stigma and hinted to regulators a bank could be in trouble. That is, until 2007.

In August 2007, as credit conditions tightened somewhat, the Fed sought to encourage banks to utilize the discount window and lowered the discount rate to just 0.50% above the federal funds target rate. But banks remained wary of the discount window, and the move drew few takers. So the Fed "encouraged" several then-healthy banks—including Citigroup, JP Morgan, Bank of America, and Wachovia (since purchased by Wells Fargo)—to symbolically borrow $500 million of unneeded funds each at the discount window as a sign the stigma was gone. Sill, interest was muted. The Fed later introduced the Term Auction Facility (TAF), a new way for banks to borrow from the Fed for longer periods without using the discount window, and the Primary Dealer Credit Facility (PDCF), which gave non-bank financial firms access to Fed money. All wacky stuff.

Borrowing from these programs peaked as the financial crisis did in late 2008. But as the panic has abated, so has their relevance. The PDFC was unused and ended earlier this month. The TAF is scheduled to end March 8th. And there discount window borrowing has been on a steady downtrend.

Do these moves suggest meaningful tightening? Hardly. In its accompanying statement, the Fed emphasized raising the discount rate didn't mean changes to the economic and monetary policy outlook stated in the January Federal Open Market Committee (FOMC) meeting. Instead, it indicated these moves were just the early stages in the normalization of credit policy. This is to be expected—the Fed took extraordinary measures to bolster liquidity during the financial crisis and, now that the financial system is on more stable footing, is understandably reversing some of the extraordinary measures. These moves are in line with the Fed's stated plans for winding down emergency liquidity programs, and overall, these recent steps are largely symbolic, minor technical changes.

We've said monetary tightening will happen gradually and is perfectly normal as the economy and credit markets recover. With recent inflation data coming in below expectations, it's clear the Fed still has quite a bit of wiggle room and can afford to maintain the historically low rates for some time yet. The same applies to other major central banks—Japan is still battling deflation, the ECB isn't likely to raise rates thanks to mild inflation and the PIIGS situation, and the UK saw some inflation, but it's widely expected to be temporary.

Around the world, central bankers are likely to keep monetary policies accommodative to avoid stifling recovery, maintaining a tailwind for stocks. Thursday's move by the Fed was nothing more than a baby step along the still-long road to more normal monetary conditions.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.


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