Fed Discount Rate Increase Could Signal Change In Policy
By David Dierking
Is the economy finally starting to turn around? If you pay attention to what the Fed is doing, you might get the impression that the answer to that question is yes.
But it’s more important to first take a look at exactly what the Fed’s been up to. A couple of weeks ago, the Fed made news by raising the discount rate – the rate that the Fed charges banks for emergency loans – a quarter point from 0.50% to 0.75%. This increase could signal a number of things regarding the Fed’s opinion of the state of the economy and that of financial institutions.
First of all, a change in the discount rate will have little effect on the average consumer. Consumers will be more affected by changes in the prime rate as that rate can be the basis for everything from credit cards to adjustable rate mortgages to HELOCs. The discount rate is used strictly for government to bank short-term lending.
But a change in the discount rate does offer a glimpse into the Fed’s current thinking. The fact that the Fed raised one of its rates is not surprising as rates really had nowhere to go but up after the Fed’s extended “free money” period. The fact that the rate was increased at this point indicates the Fed believes that the economy is on the road to recovery.
The Fed has long used rate policy as a means of containing the core inflation rate. Inflation in the recent recession hasn’t been a concern as much as easing monetary policy enough to fuel economic growth again. The Fed for the last several months has kept rates at a very low level to accomplish that but now they’re also indicating that they’re being watchful of inflationary pressures so that they won’t derail any potential economic recovery. Ben Bernanke and crew are essentially telling us that the wheels of resurgence are in motion but they don’t want to overheat the economy too fast either.
The Fed may also be stimulating banks to begin using the private sector more frequently to do business instead of the government. Through programs like TARP and a relaxed monetary policy, the government has become the de facto safe haven for many financial institutions to acquire the funds necessary to support their balance sheets and capital ratios. The Fed could now be signaling that they’re trying to start shedding this label and encourage a more normal pattern of lending amongst institutions.
The increase in the discount rate does tell us though that a more widespread tightening of monetary policy might not be too far off in the future. As the economy improves, the Fed will want to balance economic growth with inflation control. If the Fed raises rates too fast, it could push the economy back into recession. If the Fed is too slow to react, inflation will begin creeping back onto the radar. They could be looking to act in the second half of 2010 or perhaps even wait until 2011. It’ll be a balancing act worth watching.
The news of a discount rate increase should be taken as an encouraging sign. The stock market is well off its recent lows, the housing market has given indications of hitting a bottom and unemployment has slowly begun starting to move back down. It’ll be up to the Fed now to keep that momentum going.
Photo credit: Nicobobinus
This article was originally written or modified on . If you enjoyed reading this post, please consider subscribing to my full RSS feed. Or you can also choose to have free daily updates delivered right to your inbox.