Fed Discount Rate Increase Could Signal Change In Policy

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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

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Author Info

This post was written by David Dierking. David lives outside Milwaukee, Wisconsin and has been working in the financial services industry for over 13 years with a background in investments, accounting, and marketing. He earned his Chartered Financial Analyst designation from the CFA Institute in 2004 and was recently published in the Milwaukee Business Journal. You can also check him out at The Ultimate Fit Challenge

3 Responses to “Fed Discount Rate Increase Could Signal Change In Policy”

  1. JT |  Mar 04, 2010 at 4:48 pm

    “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.”

    Citation needed. :)

    I think the housing market still has a ways to go. The Fed will be ending their MBS purchasing program that bought $1.2 TRILLION in toxic securitized mortgages. That, plus a commercial real estate bust which is starting to pick up steam this year, is going to keep downward pressure on housing prices.

    And unemployment certainly isn’t down either. If anything, people are just falling off the charts which is worse because now they don’t have any income! There are no driver for jobs, no tech or housing bubble to bail us out, even temporarily.

    Roughly 70% of people over the age of 60 are delaying retirement as they have nowhere near what they need to comfortably retire. This, combined with the 1.2 million new people who annually enter the workforce, is keeping the demand for jobs high while the supply of jobs is low. College graduates are moving back in with their parents, swamped with student loan debt, and no way to pay it off.

    Deflation is here and has been for some time.

    • Sun |  Mar 08, 2010 at 10:14 pm

      Today is the anniversary of the 2009 stock market lows. The unemployment rate is steady last month. And the depreciation of house prices has slowed in recent months. I think all of these are indications that things aren’t getting worse any more. Except the stock market, which is like a leading indicator, there aren’t many clear signs that things are really improving right now either, so the Fed still said that it will keep the Fed fund rate at the current level for a while, especially when inflation is well under control. To me, the fact that the Fed raised its discount rate only means that the Fed is thinking of exiting from the current policy. But it could still be a long time from now till it actually changes its policy.

  2. Edwin |  Mar 04, 2010 at 7:11 pm

    I agree with JT on all accounts. To add a little to it, housing received a prop up due to inventories which won’t happen again.

    Also, the core CPI fell making me doubt there is any hint of inflation coming anytime soon. Hell, it’s showing the exact opposite, disinflation.

    While I won’t try to guess at what the Fed is doing (there are people who do this full-time and are mostly wrong), I can give my thoughts on what their actions can cause.

    If the Fed decides to increase the inflation target all that would do is slow down attempts to get out of this recession (which we aren’t close to out of). If the Fed keeps rates low, there wont be any threat of inflation based on all indicators.