The US Fed Raises Discount Rate-Why Did They Do It?-VRK100-28022010

The US Fed Raises Discount Rate-

Why Did They Do It?

Rama Krishna Vadlamudi                    February 20th, 2010


If you want to read about this article in a READER-FRIENDLY PDF document, JUST CLICK:

www.scribd.com/doc/27745208

On February 18^th, the US Fed has given a mild surprise to the financial markets by raising the discount rate by 25 basis points from 0.50 per cent to 0.75 per cent. This is the first major move by the US Fed as part of its exit strategy. Reacting strongly to the Fed move, the US dollar has rallied against the Euro and Pound Sterling. The dollar hit a nine-month high against euro with the euro quoting at 1.35 on Friday. The Euro’s recent high was 1.50 against the US dollar in December 2009. The dollar rallied against the Japanese Yen and pound sterling also – the Yen weakened up to 92 while the pound depreciated to a level of 1.55 against the dollar. The stock markets reacted negatively to the discount rate hike and major indices across, the US, Europe and Asia-Pacific witnessed cuts in the range of one to two per cent on Friday.

While raising the discount rate, the Fed has indicated that this is a not a signal for modifications in the outlook for the economy or the monetary policy. Several policymakers does not want to dub this as a withdrawal of stimulus, rather they would love to call it as a “normalization process,” a new word they designed for their latest actions as these financial systems seem to have come out of the crisis situation.

What inferences can be drawn from the hike in Discount Rate?

1. It seems to be the end of cheap money. Till now, investors used to resort to dollar carry trade by borrowing from the US market at zero or near zero interest rates and invest in commodities or stock markets of emerging economies. This is the serious beginning of an exit strategy from the Fed.
2. There is a marked upturn, however fragile it may be, in the US economy and as such the US Federal Reserve is more confident about the sustainability of US recovery in the next three to four quarters
3. However, Ben Bernanke, the US Fed Chairman, has stated that the interest rates will remain “exceptionally low” for “an extended period of time.” It means that the Fed may not raise the all-important benchmark Federal Funds Rate (Fed Rate) for the next three to four quarters as the US unemployment is hovering close to 10 per cent even now.
4. Even though the US fed funds rate is kept near zero, the Fed has started to unwind other unconventional liquidity measures on an ongoing basis
5. This confidence about the US recovery is good for the  US dollar and the optimism is already showing in the strength of US dollar against euro and pound sterling with the US dollar index hovering around 80 as of now
6. The strong dollar could also be a dampener for the prices of commodities in the short-term. However, the inverse correlation between the commodities and the US dollar may come to an end sooner than later.

What is US Discount Rate?

It is the rate charged by the US Fed for the banks who require emergency money for their short-term requirements. It is similar to the Repo rate in India – it is the rate at which commercial banks in India borrow funds from the Reserve Bank of India for their short-term, usually one or two days, needs.

However, the discount rate does not directly affect the borrowing rates for companies, customers or mortgage rates in the US. As such, the hike in discount rate is as merely symbolic with no impact on interest rates in the economy.

What is the difference between the Fed Funds rate and discount rate?

The Federal funds rate (or simply known as Fed rate) is currently pegged at between zero and 0.25 per cent. The Fed sets the Fed funds rate also. It is the benchmark rate at which banks lend to each other. The federal funds rate is an overnight lending rate among banks/financial institutions in the US. The rate is also used as a benchmark rate by banks to fix interest rates for other loans, like, mortgage loans, business loans, consumer loans and loans to credit card holders. The US Fed uses the federal funds rate as a tool to balance its objectives of economic growth and price stability. Whenever inflationary expectations are high in the economy, the US Fed tries to control inflation by hiking the fed funds rate. On the other hand, if there is a slowdown in the economy, it will try to inflate the economy by lowering the fed funds rate.

The Fed funds rate is similar to the call money rate through which Indian banks lend or borrow among themselves to meet their short-term funds requirements or lend their short-term surplus funds to other needy banks. However, the RBI has no direct control over call money rates in India. They are purely driven by supply of and demand for money among the commercial banks and primary dealers.