Fed Discount-Rate Increase Signals End to Emergency Measures

By Craig Torres and Vivien Lou Chen
Feb. 19 (Bloomberg) -- The Federal Reserve Board sent its most explicit signal yet that the emergency supply of liquidity to financial markets is done and the most aggressive monetary policy easing in its 96-year history will eventually reverse.
Chairman Ben S. Bernanke and his colleagues at the Board of Governors raised the rate charged to banks for direct loans by a quarter-point to 0.75 percent, effective today. It was the first increase in the discount rate since June 2006.
The Fed portrayed the decision as a "normalization" of lending that would have no impact on monetary policy, repeating in a statement in Washington yesterday that its benchmark federal funds rate would stay low for an "extended period."
The assurances didn’t stop investors from increasing bets that the Fed would tighten policy in the fourth quarter. The dollar rose and U.S. stock futures fell after the announcement.
"The discount rate historically has always been used as a psychological tool for signaling the future course of monetary policy," said Sung Won Sohn, former chief economist at Wells Fargo & Co. and now an economics professor at California State University-Channel Islands in Camarillo, California. "The bottom line is the Fed is signaling that in the future rates are more likely to go up, rather than stay stable or go down."
U.S. central bankers closed four emergency lending facilities this month and are preparing to reverse or neutralize the more than $1 trillion in excess bank reserves they have pumped into the banking system. The discount-rate increase will encourage banks to borrow in private markets rather than from the Fed, the statement said.

‘Time of Uncertainty’

"There is no way of doing this in times of uncertainty and not cause some reaction in financial markets," said David Montero-Rosen, chief investment officer at the Graham & Dodd Fund LLC in New York.
The dollar rose to $1.3485 per euro as of 1:06 p.m. in Tokyo from $1.3527 late yesterday in New York, after climbing to $1.3444, the strongest since May 18. Futures on the Standard & Poor’s 500 Index expiring in March lost 1.1 percent to 1,093.50.
Bernanke prepared investors for the move in Feb. 10 testimony to Congress, saying the discount rate would have to be raised "before long." In the minutes of the January 26-27 Federal Open Market Committee meeting released Feb. 17, policy makers said an increase "would soon be appropriate."
Even so, the increase came sooner than many analysts and investors expected.

‘Big Surprise’

"The big surprise was the timing," said Alan Ruskin, head of currency strategy at RBS Securities Inc. in Stamford, Connecticut. "This is just one more very, very clear signal that the abnormal liquidity provisions provided during the crisis are being withdrawn."
Fed Bank of St. Louis President James Bullard yesterday said expectations for an interest-rate increase were exaggerated.
"The idea that’s in markets that there’s a high probability that we’ll raise rates later this year is overblown," Bullard said in response to audience questions after a speech in Memphis, Tennessee. "There’s also some probability, maybe more, that this will extend into 2011."
Larry Meyer, a former Fed governor and vice chairman of Macroeconomic Advisers LLC in Washington, said yesterday’s decision "says absolutely nothing" about the timing of the first increase in the federal funds rate.
"We believe that the Fed will not raise the funds rate for the first time until the middle of 2011," Meyer said in a Bloomberg Television interview.

Rate Near Zero

The Fed has kept the benchmark rate for overnight borrowing between banks to a range of zero to 0.25 percent since December
2008 and repeated after last month’s policy meeting that the rate would stay low for an "extended period."
Fed officials have nevertheless been warning financial institutions to be prepared for higher rates and are keeping a close watch on leverage, market valuations and overall financial conditions. In January, the Fed Board issued an advisory with other regulators urging banks to strengthen their management of interest-rate risk.
Yesterday’s announcement was "basically a psychological message to the marketplace that at some point the Fed does have to begin to pay attention to the potential of inflation down the road," Kelly King, chairman and chief executive of BB&T Corp., said in an interview with Bloomberg Television. "I don’t think they are going to be moving short-term rates anytime in the very near future."

Regional Fed Banks

King is a member of the Richmond Fed’s board of directors, which, like the 11 other regional Fed boards, has the authority to request changes in the discount rate. Those requests are subject to final review and determination by the Board of Governors. The Board said yesterday it approved requests for the rate increase from all 12 regional Fed banks.
Lenders have borrowed less from the Fed’s district banks as the crisis ebbed and the economy returned to growth.
Financial institutions have reduced their reliance on the Fed window. Banks had borrowed $14.1 billion as of Feb. 17, representing less than 1 percent of the central bank’s $2.28 trillion in total assets. A year ago, borrowing stood at $65.1 billion. The Fed continues to add reserves to the banking system with its purchases of $1.43 trillion in housing debt, which are scheduled to end next month.
Bernanke used the discount rate as his first policy tool to attack the financial crisis.
Before August 2007, the discount rate was set at one percentage point above the federal funds rate. As subprime mortgage defaults began to ripple through the financial system in August 2007, the Fed reduced the spread to half a percentage point and lengthened the term to 30 days from overnight.

Bear Stearns

Following the rescue of Bear Stearns Cos. in March 2008, the Fed again lowered the spread to a quarter point and extended the term to 90 days.
The term was later reduced to 28 days. Yesterday, the Fed board said that effective March 18, the maturity on discount- window loans will be shortened to overnight.
The changes 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,"
yesterday’s statement said.
Fed officials reinforced the message in speeches that were previously scheduled for last night.
Atlanta Fed President Dennis Lockhart told a Georgia business audience that policy "remains accommodative." Fed Governor Elizabeth Duke, speaking in Norfolk, Virginia, said the steps "do not signal any change in the outlook for monetary policy."