federal reserve

Don't fret over hike in discount rate

Friday Feb. 19, 2010
Posted 11 a.m. EST

Late yesterday the Federal Reserve announced an increase in the discount rate, not the more important federal funds rate. Let me type that again: The Fed did not increase the all-important federal funds rate. So what is the discount rate and what, if anything, is the significance of this?

The discount rate is what banks pay to borrow directly from the Federal Reserve. The term "discount" is a misnomer as there's no discount. In fact, it is by design a somewhat punitive rate designed to encourage banks to tap other sources of funds rather than relying on the Fed. The Fed is still -- and always -- the lender of last resort, but it's a little more costly to use that lifeline now. This is just another step to mop up liquidity and reign in the liquidity programs created by the Fed in response to the seizing up of credit markets.

Essentially, Mom just raised the rent on her 20-something child. Mom is still Mom. She's not kicking you out, she's just saying it's time for you to get your own place. And she's encouraging that by leaving a copy of the local rental listings and a note telling you the rent she's charging will be more than what those nice apartments down the street will charge.

Most importantly to consumers, the discount rate does not -- I repeat, does not -- have any direct impact on interest rates paid for loans (or sadly, earned on deposits). Could this lead to higher mortgage rates? If the market takes this move to believe the Fed is closer to raising the federal funds rate or the rate paid on excess reserves, then yes. After the initial shock wears off, this may prove to have little impact on mortgage rates compared to the inflation data and other rosier economic reports that have been coming out. What is certain to be far more impactful to mortgage rates is when the Fed stops buying mortgage-backed securities at the end of March. I expect a half-percentage point increase in mortgage rates relative to yields on 10-year U.S. Treasury notes when that happens.

Does this mean the Fed is closer to hiking short-term rates? I don't believe so. If anything, this will buy them even more time before doing so. The Fed has been very consistent about saying rates will stay low for an extended period of time and raising the federal funds rate or the rate on excess reserves clearly appears to be the last lever they want to pull, waiting for further economic and employment improvement to materialize.

If I may digress just a bit, I had quite the déjà vu feeling yesterday when the announcement was made. I happened to be at a meeting in a hotel when the Federal Reserve's press release popped into my e-mail inbox. I immediately recalled the day in Aug. 2007 when the Fed initially cut the discount rate -- but not the federal funds rate -- in an effort to ease funding pressures for banks. This was when the credit crunch had first grabbed a hold of the markets. What was I doing at the time? I was in a meeting ... at the same hotel.

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