Fed Hike : What does it mean

Discount Blues
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The Federal Reserve 25 basis point discount rate increase on Thursday to 0.75% was not a market moving event. The first Fed hike in either the discount rate or the more important fed funds rate in almost two and a half years will have little direct economic impact. It had no effect on the bond or mortgage market and little on banks whose Fed borrowing is directly subject to it. The 10 year Treasury closed higher on Friday.

The discount rate is not unimportant but its meaning is largely symbolic. It is the rate at which banks borrow overnight funds from the Fed at the discount window rather than in the private sector money markets. But since almost no bank has been using the window the hike will have no material effect on banks' cost of funds.

Historically the discount rate has been about 1% over the federal funds rate; essentially it is a penalty charge. With fed funds at 00%-0.25% the discount rate has probably two more 25 basis point hikes in the immediate future. The Fed itself said the increase represented a 'normalization' of lending rather than a change in policy. The FOMC statement for more than a year has included its assessment of the US economy as needing low rates "for an extended period" and Fed officials repeated this on Thursday when they announced the discount hike.

The fed funds rate is properly the Federal Funds Target Rate. It is where the Federal Reserve aims to keep rates in the private money markets by example and by intervention through the trading desk of the Federal Open Market Committee (FOMC). If banks cannot access the private markets because of credit or liquidity constraints then they can borrow from the Fed directly at the discount window. Because of the implied impairment witnessed by use of the discount window banks have always been extremely reluctant to take this route. The window lets the private credit and equities markets know that an institution is in trouble, hence the term 'discount window stigma'.

The increase in the discount rate is a measure of the Fed and Ben Bernanke's willingness to return to normal interest rates and an estimate of the evolution of their economic and financial concerns.

Banks and the banking system are no longer on the front lines of distress. If they were or if the government still had serious concerns about their capital or asset structure the Fed would not have risked even this symbolic step. If the reported profits and bonuses of some of the banks that took government TARP money are one sign of returned corporate health, this rate increase is a second.

Consumer inflation, headline and core, are benign. In January CPI gained 0.2% and the core measure was negative at -0.1%. The year over year readings were 2.6% and 1.6% respectively. This was the first monthly fall in core inflation since December 1982. It has long been the Fed contention that inflation would be restrained by the recessionary inability of firms to raise prices and the deflationary effect of unemployment on wages.

But inflationary indicators are stirring. In January the Producer Price Index (PPI) gained 1.4%, almost double the expectation and more than three times the December reading of 0.4%. The yearly result was 4.6%; in December it was 4.4%. Over the past six months the rate of wholesale inflation has been 9.8%. The Fed may be correct that firms are currently unable to pass along price increases. But PPI seems to indicate building inflationary pressures that even a modest decrease in the unemployment rate may remit into consumer and wage inflation.

The Fed's estimated range for GDP growth this year of 2.8% to 3.5% will not appreciably reduce unemployment. The recent up tick in weekly jobless claims, the four week moving average has gained almost 27,000 in the New Year, a warning on the complete lack of job creation.

The discount rate hike is symbolic anti-inflation rhetoric. The Fed is unable to make a substantive rate move, even if it wanted to, in the face of a very weak job economy and uncertain prospects for long term employment growth.

More important for the real interest rate market is the ending of the Fed's MBS purchase program and its impact on residential and commercial mortgage rates and the housing market.

Housing is directly tied to the health of the banks and the stability of the financial system. Many institutions still hold large amounts of asset-backed paper with questionable mortgage portions. The housing market remains very weak and in most measures is close to historic lows. If the withdrawal of Federal support for the housing securitization market causes a spike in mortgage rates, and the Fed cannot be certain that will not happen, then the entire cycle of falling housing prices devaluing the existing mortgage assets on bank books, requiring more support capital, the cycle that almost brought down the system last fall, could reignite.

The possibility of the asset write-downs triggering capital requirements in the financial sector is considerably less than it was in the fall of 2008 because some of the mark-to-market rules have been relaxed. Banks no longer have to price assets for which there is no market reference well below residual value. Still, after the 2008 near death experience, Ben Bernanke and the Fed Governors will take no chances.

In the current American economic environment of low actual inflation, weak GDP growth, nonexistent job creation, a moribund and still dangerous housing market and a financial sector only in remission, the symbolic placebo of the discount rate is all the anti-inflation medicine the Fed can afford to prescribe.