Federal Reserve Has Raised the Discount Rate to 0.75%

The Federal Reserve has raised the Discount Rate to 0.75% from 0.50%.

This should not surprise regular EPJ readers, despite CNBC saying it was a surprise:

Market watchers were shocked by the unexpected announcement, which came after markets closed Thursday.

Huh. Obviously not EPJ readers.

Last week in an analysis of prepared testimony by Bernanke I wrote:

2. The Fed appears ready to raise the discount rate as a symbolic measure.

I also anticipated a potential panic response by traders (which is occurring future are getting killed, gold is plunging and the dollar is soaring. I wrote:

If the market drops on news of the discount rate hike, it's a signal that there are a lot of clueless traders out there.

There should be heavy emphasis on this being symbolic. It won't impact the money supply or monetary reserve, but the symbolism is deep. The next hike will be in the Fed Funds rate and, most importantly, the IOER.

This will not be symbolic, it will be devastating. It signals the Fed really does believe the key is to control interest rates and not the money supply. By raising the IOER, even more money will be pushed to the sidelines into excess reserves and even fewer loans will be made. In other words, the second dip of this double dip recession could be more like a plunge. With China in a tightening mode already and this symbolic move from an already slow money growth Fed, the downside activity in the stock market and gold will intensify. Cash, specifically, the dollar will be king.

Of further note, the timing of this release on a Thursday after the markets closed is interesting. It is likely to be the future method of operation for this Fed. The thinking has to be:

1. The Fed will, of course, wait until after the market closes to make the announcement.

2. The Fed makes the announcement on a Thursday so that there is one day of market action (Friday) to gauge impact, but then two off days to regroup if the reaction is extremely severe.

Here's the Fed's full release:

The Federal Reserve Board on Thursday announced that in light of continued improvement in financial market conditions it had unanimously approved several modifications to the terms of its discount window lending programs.

Like the closure of a number of extraordinary credit programs earlier this month, these changes are intended as a further normalization of the Federal Reserve's lending facilities. 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, which remains about as it was at the January meeting of the Federal Open Market Committee (FOMC). At that meeting, the Committee left its target range for the federal funds rate at 0 to 1/4 percent and said it anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

The changes to the discount window facilities include Board approval of requests by the boards of directors of the 12 Federal Reserve Banks to increase the primary credit rate (generally referred to as the discount rate) from 1/2 percent to 3/4 percent. This action is effective on February 19.

In addition, the Board announced that, effective on March 18, the typical maximum maturity for primary credit loans will be shortened to overnight. Primary credit is provided by Reserve Banks on a fully secured basis to depository institutions that are in generally sound condition as a backup source of funds. Finally, the Board announced that it had raised the minimum bid rate for the Term Auction Facility (TAF) by 1/4 percentage point to 1/2 percent. The final TAF auction will be on March 8, 2010.

Easing the terms of primary credit was one of the Federal Reserve's first responses to the financial crisis. On August 17, 2007, the Federal Reserve reduced the spread of the primary credit rate over the FOMC's target for the federal funds rate to 1/2 percentage point, from 1 percentage point, and lengthened the typical maximum maturity from overnight to 30 days. On December 12, 2007, the Federal Reserve created the TAF to further improve the access of depository institutions to term funding. On March 16, 2008, the Federal Reserve lowered the spread of the primary credit rate over the target federal funds rate to 1/4 percentage point and extended the maximum maturity of primary credit loans to 90 days.

Subsequently, in response to improving conditions in wholesale funding markets, on June 25, 2009, the Federal Reserve initiated a gradual reduction in TAF auction sizes. As announced on November 17, 2009, and implemented on January 14, 2010, the Federal Reserve began the process of normalizing the terms on primary credit by reducing the typical maximum maturity to 28 days.

The increase in the discount rate announced Thursday widens the spread between the primary credit rate and the top of the FOMC's 0 to 1/4 percent target range for the federal funds rate to 1/2 percentage point. The increase in the spread and reduction in maximum maturity will encourage depository institutions to rely on private funding markets for short-term credit and to use the Federal Reserve's primary credit facility only as a backup source of funds. The Federal Reserve will assess over time whether further increases in the spread are appropriate in view of experience with the 1/2 percentage point spread.

Okay, remain at battle stations. The next increases will be in the Fed Funds rate and the IOER and they are going to be direct hits.