Sunday, February 21, 2010

OMG! - The Fed Raised the Discount Rate

Last week the Federal Reserve raised the Discount Rate by .25% to .75%. "OMG!" was the response by the markets on Thursday. We also saw mortgage rates rise last week. What did the Fed really do, and what does it mean to you?

Discount Rate, Fed Funds Rate & Their Purpose
The Federal Reserve (Fed for short) controls two interest rates: the Fed Funds Rate; and the Discount Rate. Both are short term interest rates used by the Fed to make monetary policy. It is important to know the difference between the two rates. The Fed Funds Rate is the rate that banks charge each other to borrow funds overnight. The Discount Rate is the cost to banks to borrow funds directly from the Federal Reserve.

The Fed prefers the banks to lend to each other (via the Fed Funds Rate) so that it does not have to lend directly to banks. Therefore historically, the Discount Rate has been a full percentage point higher than the Fed Funds Rate, so that the Fed was the lender of last resort to banks. However, that practice changed in August of 2007 when credit markets began to show signs of weakness and the Fed wanted banks to be able to borrow from the Fed if necessary. At that time the Discount rate was lowered by .5% without changing the Fed Funds. Subsequent rate decreases followed as the recession began and the credit freeze took hold.

What They Did & Why
So the Fed raised the interest rate tied to funds that it lends to banks from .5% to .75%, why? In a statement the Fed gave their reason as, "to encourage depository institutions to rely on private funding markets for short term credit." In other words, lend to each other so that we (the Fed) don't have to.

That seems fairly benign. Only $15 billion is currently being borrowed from the Fed. So why were the markets startled at first? Some are concerned that this is the first step in a new climate of tighter monetary policy, better known as higher interest rates.

Atlanta Fed President Lockhart seemed very clear on Thursday when he said that people "should not interpret this action as a tightening of monetary policy or even a sign that a tightening is imminent."

I believe him. Our economy is still much to week to begin tightening credit. Credit is already too tight. Rather this move seems to only to attempt to get closer to the 1% spread between the Discount Rate and the Fed Funds Rate that existed prior to August 2007.

What Does the Discount Rate Matter to You?
Unless you are a bank that borrows money from the Fed, then this probably won't impact you at all. The Fed will keep short term rates low (via the Fed Funds Rate) until the economy shows signs of improvement.

The larger concern for mortgage rates rests in the Feds Mortgage Bank Security purchase program (see January 9 post) which is slated to end next month. Expect to see rates bump up unless the program is extended.