Fed seeks to calm markets after discount rate rise

US Federal Reserve officials moved to calm speculation that a surprise rise in its emergency lending rate could bring forward broader policy tightening, saying borrowing costs in the economy would stay low.

Fed Chairman Ben Bernanke flagged the move last week, saying the US central bank aimed to widen the spread between its main policy rate that remains pegged near zero and the discount rate at which banks can borrow from the Fed.

However, no one in markets expected it to act so soon and the timing of the move – well ahead of the March 16 policy meeting – prompted investors to price in a greater likelihood of a rise in the benchmark fed funds rate late this year.

The dollar jumped and government bonds and bank stocks fell after the Fed raised the discount rate by 25 basis points to 0.75 percent even as it cast it as a response to improved financial market conditions and not a change in monetary policy.

“This is a significant and likely symbolic move that will impact on market sentiment,” Robert Rennie, a strategist at Westpac in Sydney said in The Dealing Room, a Reuters Messaging chat room.

“The emergency easing cycle began with discount rate cuts – it was all about easing liquidity to banks. So the move to raise the discount rate means the long journey towards normalisation has begun.”

Thursday’s move is the first increase in any of the Fed’s lending rates since the financial crisis blew up in 2007 and the first rate change since December 2008.

“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,” the Fed said in a statement.

Overblown expectations
While investors initially brushed aside the Fed’s assurances that no tightening for the broad economy was on the cards, warnings from a senior Fed official that markets have gone too far in their tightening bets finally did sink in.

St. Louis Federal Reserve Bank President James Bullard said investors belief in high probability of a rise in the Fed’s benchmark rate this year was “overblown” and that the discount rate rise should not be seen as a policy signal.

“The discount rate move is part of a normalisation process which is akin to our discontinuing many of our liquidity programs,” Bullard, who votes on the Fed’s interest rate-setting panel this year, told reporters in Memphis. “It does not indicate anything one way or the other about what we might eventually do with the federal funds rate,” he added.

The dollar pared gains and treasury futures trimmed losses, after Bullard’s comments and reminders from fellow Fed officials that cheap credit was still the order of the day.

“Monetary policy – as evidenced by the fed funds rate target – remains accommodative,” Dennis Lockhart, Atlanta Fed president, said in a speech. “This stance is necessary to support a recovery that is in an early stage and, in my view, still fragile.”

Still, share markets in Asia were on the defensive as the Fed’s action, which follows China’s moves to curb lending, served as a reminder that the period of cheap cash that fuelled last year’s stock market rally may be slowly drawing to an end.

Return to normal
Before the financial crisis, the discount rate was typically a full percentage point above the federal funds rate. Thursday’s decision begins to move it back nearer to its traditional premium and it said it would assess over time whether it needed to further widen the spread between the two rates.

The central bank’s view of the economy has brightened in recent months as job losses eased, consumer spending strengthened and businesses stepped up purchases of equipment and software. The Fed has warned, however, that recovery from the deepest US recession since the 1930s will probably be sluggish and has said it expects to keep the federal funds rate near zero, where it has been since December 2008, for “an extended period.”

In its statement on Thursday, it said the economic and policy outlook remained broadly unchanged from late January, when its policy committee reiterated that low-rate pledge.

Some other central banks around the world have begun to tighten policy. Australia led the way last year and its central bank chief signalled on Friday more rate increases in months ahead while China surprised markets twice in the past two months by lifting banks’ mandatory reserves.

In the US, however, the Fed has said record low interest rates are still warranted with the unemployment rate near 10 percent.

“I don’t think the Fed dares (to) increase the fed funds or policy rate in the face of unemployment at double-digit type of levels,” Bill Gross, the manager of Pimco, the world’s biggest bond fund, told reporters after the Fed announcement.

Other changes announced on Thursday included shortening the typical maximum maturity for primary credit loans to overnight from 28 days, effective March 18, and raising the minimum bid rate for the Fed’s Term Auction Facility, another scheme put in place to foster market liquidity.


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