The Fed Hikes The Discount Rate: Another Step Toward Normalization
By Gus Krafve
March 3rd, 2010
Effective February 19, 2010, the Federal Reserve Board raised the discount rate by 0.25% to 0.75%. It was the first increase in the rate since May 10, 2006. The discount rate is the interest rate that a bank is charged to borrow short-term funds directly from a Federal Reserve Bank. This is not to be confused with the Fed Funds rate which is the interest rate that a bank lends its balances at the Federal Reserve to another depository institution overnight. The Fed Funds rate is still in its 0-0.25% range which is where it has been since December 16, 2008. When the Federal Reserve changes the Fed Funds rate, most banks will change their loan and depository rates accordingly to mirror the Fed.
While raising the discount rate was a step toward normalization, it was only a baby step. Economic activity still has a way to go before it gets strong enough to warrant a hike in the Fed Funds rate. The Federal Reserve Board emphasized that raising the discount rate did not signal any change in the outlook for the economy or for monetary policy and was not expected to lead to tighter financial conditions for households and businesses. It even reiterated that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”
The two main factors we are looking for as a harbinger to the Fed raising the Fed funds rate are as follows:
• A declining unemployment rate. This rate has ticked down recently to 9.7%, but it will need to trend significantly lower before the Fed will begin raising rates, in our opinion. Over 60% of the US economy is tied to consumer spending and a high unemployment rate means inflation will likely stay subdued.
• Restored health to the banking system. While the banking system is clearly on the mend, there is still an elevated level of bank failures and the quality of the assets that banks hold is still in question. An improving economy and this extended period of extremely low short-term rates are keys to improving the foundation of the banking system. One sign of this restored health will be when bank lending returns to more normal levels. While a notable increase in bank lending will be a positive for the economy, it will also likely lead to inflationary pressures. Thus, we would look for the Fed to head off inflation by raising the Fed Funds rate.
Unfortunately for investors, extremely low short-term rates are likely to remain for the next several months. As investment managers, we are diligently working to keep excess cash invested, while remaining focused on investing in high-quality investments. We appreciate your continued patience during this challenging interest rate cycle.
