Wednesday, February 10, 2010

Fed change in policy? Raising discount rate

Bernanke --- "Before long, we expect to consider a modest increase in the spread between the discount rate and the target federal funds rate. These changes, like the closure of a number of lending facilities earlier this month, should be viewed as further normalization of the Federal Reserve's lending facilities, in light of the improving conditions in financial markets; they are not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signaling any change in the outlook for monetary policy..."

This will normalize monetary policy. The question is whether it will be meaningful and of course, when will it happen. The symbolism will be strong. The actual effect will be small.

The discount rate is usually higher than the Fed funds rate and has been used as a rate or place for last resort bank borrowing. During the crisis there was some stigma with using the discount rate window. It was viewed that discount borrowing meant that you could not get the money in the Fed funds market. This may not be true, but it was the perception. Raising the rate will not change the fact that we are awash in excess reserves that can be borrowed at close to zero. Raising the discount rate will force more borrowing into the Fed funds market which would be more normal.

There is no reason why the discount rate should not be raised. It could happen soon which means within the next two quarters.

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