Friday, February 19, 2010

Fed Shocks Market With Largely Symbolic Discount Rate Hike

Yesterday afternoon, the Federal Reserve announced a hike in the discount rate from 0.50% to 0.75%. Everybody panicked, sold equity futures and bought dollars. While the Fed had already made clear that a hike in the discount rate would likely be the first move towards reversing the extraordinary monetary easing of the past two years, the market was positively flummoxed. Despite accompanying comments from the Fed stating the "modifications 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," market participants were scrambling to interpret the move. Traders of all products were seen running around in circles after the close yesterday grabbing each other by the collar and screaming "I know they said it doesn't mean anything, but WHAT DOES IT MEAN???!"

After all, if the move was completely meaningless, why do anything at all? And why announce it at a weird time on a day when nobody was looking for the Fed to make an announcement? In its effort to keep from roiling the market, at least the folks at the Fed made the announcement after the close. But still, has Mr. Bernanke not heard of after-hours trading?

The discount rate, for those who are still unclear on the difference between the Fed's money market rates and various facilities, is the rate that banks can borrow from the Fed's emergency discount window. Up until the most recent credit crisis, NOBODY borrowed from the discount window, EVER unless they were minutes away from bankruptcy. In fact, rumors of a bank needing to borrow from the discount window could cause a run on the bank. Until the Fed relaxed the rigid rules of borrowing from the discount window during the height of the panic, investment banks on the brink would go knocking, begging to the Fed's discount window (i.e Drexel, Bear etc.) only to be turned away. Even though the Fed tried to encourage banks to borrow during the height of the crisis and ignore the stigma, it still refuses to hand over the names of the banks who were borrowing from the discount window. The stigma still exists even though nobody wants to admit that there is still a stigma.

So why, for the love of God, would the Fed raise the discount rate? Why make an announcement when nobody is expecting an announcement from the Fed? What purpose can it possibly serve? If it's largely symbolic, why accompany the move with a statement that says don't read anything into this? I believe that this is a big hint to the credit markets. The easy money party is nearly over. Be prepared for the Fed to turn on a dime and start making moves that aren't largely symbolic. Take heed. You have been warned.

1 comment:

Mr Wrightwood said...

Foreshadowing and symbolism? Holy cow, the Fed has been taken over by my eighth grade lit teacher!!! I hope that doesn't mean I have to reread Young Goodman Brown to devine what the Fed might do next. Here come those frikken school dreams again.