An otherwise quiet week was stirred up on Friday by the Federal Reserve’s decision to increase its discount rate from 0.50% to 0.75%.
Fed officials were quick to follow up with reassurances that this didn’t represent a monetary tightening, and that their main policy rate – the Fed funds rate – is still expected to stay low for “an extended period”.
First impressions are that this won’t immediately lead to higher interest rates.
The discount rate is where the Fed will lend overnight cash to banks, effectively placing an upper bound on the rates at which they borrow and lend among themselves.
Raising that upper bound implies that market rates could also move higher, but that seems unlikely: the market rate ultimately depends on the relative power of borrowers and lenders. At the moment the banking system is flush with cash, sitting in reserves at the Fed and earning zero interest. Any bank looking to borrow overnight will still be able to negotiate a relatively low rate (in recent months it has been 0.10-0.15%).
However, the move probably was significant as a signal of the Fed’s intention to press ahead with the normalisation of monetary policy. And the speed with which they acted is certainly worth noting.
On 10 February, Chairman Bernanke told Congress that “before long, we expect to consider a modest increase in the spread between the discount rate and the target federal funds rate”; just nine days later the decision had been made.
