The Federal Reserve Board’s decision to increase the discount rate – what it charges banks for emergency loans – from 0.50% to 0.75%, should not be interpreted as a change in its monetary policy. If it was, this would impact the borrowing costs for households and businesses.
The Fed wants the market to know that this is not a tightening move of any kind. Instead, the it should be seen as a logical step along the path of further
normalization of the Fed’s lending facilities. It is part of the first phase of withdrawing liquidity and winding down emergency programs, and follows the closure of a number of credit facilities.
“This step should not be viewed as a measure of monetary tightening,” according to UBS Wealth Management.
It noted that prior to the financial crisis, the Fed maintained a 1% spread between the target Federal Funds rate and the discount rate and only offered overnight loans. The latest move brings the spread back up to 0.5%.
UBS also pointed out that discount window borrowing has been a trickle compared to other liquidity provisions by the Fed.
Despite the fact that this change is cosmetic only, the psychological impact of the rate increase is real and is material nonetheless, according to Dennis Gartman. In Friday’s edition of The Gartman Letter, he used the nautical metaphor of a “warning shot across the bow” of the capital market.
“Rather than waiting to change the rhetoric in the language of the next communiqué following the next FOMC meeting, the Fed has issued its warning shot in the form of this discount rate change,” Mr. Gartman wrote. “Cosmetic changes can be formidable in people and in economics, and this one such formidable costmetic change.”
National Bank Financial chief economist and strategist Stéfane Marion noted that despite the action, the gap between the Fed Funds target rate and the discount remains below its pre-crisis level of 100 basis points. Mr. Marion continues to expect a change in the Fed’s monetary policy stance will begin in August 2010.
The economist noted that Ben Bernanke’s prepared remarks, back when he was snowed in on Feb. 1, showed that an increase in the discount rate was coming.
“We have reduced the maximum maturity of discount window loans to 28 days… Also, before long, we expect to consider a modest increase in the spread between the discount rate and the target federal funds rate. These changes, like the closure of a number of lending facilities earlier this month, should be viewed as further normalization of the Federal Reserve’s lending facilities, in light of the improving conditions in financial markets; they are not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signalling any change in the outlook for monetary policy, which remains about as it was at the time of the January meeting of the FOMC.”