Will the Fed’s rate hike decision push the dollar to the summit, or will we see the greenback start to tumble?
The Fed’s unexpected move, last Thursday, to raise the discount rate by 0.25% to 0.75%, sent shockwaves around the forex market – resulting in the US dollar to spiking to an eight month high against its major currency counterparts.
Though it has ended some emergency lending, the Fed is being very cautious with its actions for fear of spooking investors and thwarting the rebound in the housing market and the overall economy. Fed policy makers insist that “these changes are intended as a further normalization of the Federal Reserve’s lending facilities.” And that “the moves do not signal any change in the outlook for the economy or for monetary policy.”
Nonetheless, a hike in the discount rate sends a clear message that the Fed is anxious to withdraw some of the massive stimulus efforts rolled out throughout the recession. Some analysts even believe that if the economic recovery continues on its current path, then later this year, the Fed may begin to raise the broader federal funds rate- which do have a directly affect mortgage rates.
However, to fully understand the significance of last week’s increase in the Fed’s discount rate; one must review its context in recent history. By definition, the discount rate is the rate at which member banks may borrow short term funds directly from a Federal Reserve Bank. Almost three years ago, in August 2007, the central bank began to lower the discount rate as the credit crunch took hold with the collapsing subprime-mortgage market. In order to encourage cash-strapped banks to borrow funds –funds needed to carry them through the credit crunch, the Federal Reserve began to cut the discount rate to historically low levels. The Fed’s first policy action during the mounting financial crisis in the fall of 2007 was a mere 0.5% point reduction in its discount rate from 6.25% to 5.75% percent. While this action surprised most observers who had grown accustomed to focusing only on the Fed’s target Federal Funds rate, the decision made sense as the discount window and the discount rate were the best tool available to the Fed to deal with the upcoming financial crisis.
Historically it has been against the rules for banks to engage in arbitrage by borrowing at the discount rate and lending in the Fed Funds market at a higher rate. Having the discount rate higher meant that, in normal times, borrowing in the Federal Funds market would be less expensive than borrowing from the Fed. However, during unusual periods of reserve shortages in the banking system, the Federal Funds rate would be bid up above the discount rate and trigger borrowing from the Fed.
Borrowing from other banks in the Fed Funds market does not create new reserves for the banking system- instead it just transfers existing reserves among banks. While on the other hand, borrowing at the discount window, does create new reserves for the banking system and does increases the system’s capacity for expansion.
Back in September 2007, when the Fed deliberately choose to reduce the discount rate, but at the same time keep the Federal Funds rate unchanged, it was purposely increasing the probability that banks would shift their borrowing to the Fed and trigger reserve and monetary expansion. By reducing the discount rate, the Fed intentionally abandoned the traditional 1% differential in order to deal with the crisis. But this reduction was never intended to be permanent. As time went by, the Fed routinely kept cutting the discount rate, to its previous record low level of 0.5%.
The background described above suggests that yesterday’s action should not be taken as a tightening of monetary policy so much as the beginning of a return to the preferred relationship between the Fed’s two policy rates. The willingness of policymakers to raise the discount rate can be viewed as the latest sign that the economy is regaining its footing after tumbling into the worst financial catastrophe the world has seen since the Great Depression. The Fed is implying that conditions are beginning to return to normal, and therefore the next step is to push to banks to boost lending. While a raise in the discount of 25bps is far from real a significant number, the Fed is trying to send a none-too-subtle message that the U.S government can no longer continue to do business for virtual nothing. This first step towards “the beginning of the end of bailouts”.
Tomorrow investors will be better able to gain a better understand, both of psychology and the timing behind the unanticipated rate hike, as the U.S Federal Reserve Chairman Ben Bernanke will begin his two day annual Humphrey-Hawkins testimony on monetary policy before Congress. Investors around the globe are eager to hear more about the thinking, and logic behind the surprise timing of the move to raise the discount rate, after three years, especially as the Fed’s current easy monetary policy has been crucial to the economic recovery of the US.
If Bernanke’s statements “discourage an early monetary tightening policy” the dollar will likely fall against its major currency counterparts, and be forced to forfeit some of last week’s heavy gains. Already yesterday and this morning, the dollar fell against 12 of its 16 major counterparts on speculation that Bernanke will tell Congress that last week’s increase in the discount rate intent is not to drive up borrowing costs.
