Discount Rate Increase NOT Tightening

The Fed announced a surprise quarter point increase in its discount rate, taking the rate it charges banks for short-term loans to 0.75%. This is the first rate increase of any type by the Fed in almost four years.

But the discount rate should not to be confused with the more important Fed Funds rate, which is the primary building block of all the interest rates in the broader economy. The Fed Funds rate currently remains at an extremely low level (at the 0 to 0.25% range), and the Fed has been indicating that it intended to keep it there for an ‘extended period.’

Before the financial crisis, the spread (or gap) between the discount rate and the Fed Funds rate was a full percentage point. The idea was to discourage banks from using it and to rely on it only in extreme circumstances.

Because of the extraordinary nature of the use of this facility, there has always been a stigma associated with using the discount window. So, if a financial institution was relying on the discount window (instead of the Fed funds market) for its short-term funding needs, then it must be in some sort of serious trouble. To encourage banks to start relying on the window, the Fed reduced the spread (with the Fed Funds rate) eventually to a quarter point or 25 basis points. Yesterday’s move takes the spread to 50 basis points.

How significant is it?

In the depth of the financial turmoil in the last quarter of 2008 (following the Lehman Brothers blow-up), the Fed discount window loans exceeded $100 billion. The amount outstanding now is less than $15 billion. So the wide majority of banks will essentially be unaffected by this move. In other words, the cost of funds for the average bank out there will be unaffected by this Fed move.

As such, the move is not expected to affect funding conditions in the banking system. It is expected to serve more as a catalyst for changing perceptions about the economy than actual funding backdrop. We fully agree with the accompanying statement that emphasized that the move did not signal a change to the Fed’s monetary policy stance and should not result in reduced credit to households and businesses. In terms of its signaling power, the move indicated a normalization of the monetary system from the extraordinary times of the crisis.

Why is the market surprised?

With the financial system back on its feet and the broader economy recovering, albeit with persistent doubts over the sustainability of its current trajectory, the Fed has been expected to remove some or all of the  extraordinary measures that it put in place during the crisis. Raising the discount rate was one such measure that the Fed would be expected to pursue once conditions started stabilizing. And the Fed has been hinting at just such moves for awhile now.

But the Fed’s announcement yesterday still took the markets by surprise. The only explanation I have to the market’s reaction is that the market is reading too much into an otherwise technical move by the Fed. This is not the tightening that everyone has been trying to handicap for a long time now.  If anything, the Fed’s move should assure us that the economy appears to be on a sound enough footing.