Thursday, February 18, 2010

A Rate Hike That Wasn't

After the close of the market today, the Fed raised the "discount rate" by .25% to .75%. Headlines immediately appeared on many Internet sites that the Fed had begun the process of tightening interest rates. Stock futures fell by 1%. Mr. Bernanke tell us it IS so; tell us that you have evidence that we do not yet see. Evidence that the economy is improving enough to start hiking rates. From the cliff hanging experience of 1929-type depression fears that we have been nursing over the last year, such an expression of good news would be cause for, well, a Mardi Gras type party right down the middle of Wall Street, or whichever street we happen to inhabit. But alas, a hike in the discount rate is technically a non event because banks only use the discount window in emergencies. The Fed Funds market is where most bank short-term lending and borrowing is done, and the Federal Reserve's news release is clear that the Fed Funds rate is not changing. Indeed, the most recent language from the Fed suggests that the Fed Funds rate is not likely to change anytime soon. But if the discount rate hike is completely unimportant, then why did the Fed go to the trouble of raising it? Call it the Fed's adherence to protocol. While the discount window is normally a place for emergency borrowing, it was a tool that the Fed used during the "valley of the shadow of death" when banks were so fearful of each other that they would not loan excess reserves to their brethren, even on an overnight basis. The Fed encouraged many big banks to borrow from the discount window as cover for banks who were being shut out of the Fed Funds market, as a result of loan losses and liquidity fears. The good news in the discount rate hike is the implication that the Federal Reserve now believes that the Fed Funds market has healed and that banks no longer fear each other's balance sheets the way they did a year ago. I think the Fed is merely giving cover to the banks that they encouraged to use the discount window to exit and return to the Fed Funds market. A true Fed rate hike would not be welcome news to most investors, but it would be to me. It would speak volumes about the nascent strength that is building in the US economy. We should all be hoping that a strengthening economy would force the Fed to move. The market won't like it for a day or two, but after what we have been through, it would be the surest sign that growth has taken root. Unfortunately, the Fed's action tonight doesn't carry that implication. But it does signal that the Fed Funds market has returned to normal, or close to it. That may be better news than most of us can understand.