No Discount Rate Hike, but Another is Coming

Speculation swept NY on Thursday that the Fed could raise the discount rate. We were unconvinced and sure enough no discount rate hike was delivered. However, a discount rate hike before the end of the month cannot be ruled out.

On Feb 18th the Fed hiked the discount rate by 25 bp to 75 bp. Perhaps because it was the month anniversary some chins starting wagging, but one of the criticisms now levied against the Fed is that after allegedly leaving rates too low for too long, when it did begin raising rates it did so in a predictable fashion which did not encourage more prudent risk taking. There is not reason to have expected the Fed to celebrate the one month anniversary with another hike.

When it did raise the discount rate, the Fed--Bernanke himself--signaled it would be taking place soon and after the hike was delivered Fed officials were quick to explain that it was about liquidity management not about monetary policy.

The same logic is still operative. Prior to the crisis, there was 100 bp spread between the Fed funds target and the discount rate. That spread stands at 50 bp now. There is room then for 25-50 bp in hikes in the period ahead.

Why is a hike this month likely ? The Fed is winding down several emergency lending programs and finishing its long-term asset purchases this month. A discount rate hike in this context would again help the market recognize this as a liquidity management tool and not a monetary policy signal.

Moreover, if the goal is to encourage banks to return to the Fed funds market, then the 25 bp discount rate hike in February does not appear sufficient. Discount window borrowings have hardly changed over the past month.

The upcoming speeches by Fed officials will be scrutinized for guidance and in particular the separation between liquidity and monetary policy. And while the Fed may be perfectly clear and correct that the discount rate hike has not bearing on monetary policy, the market knows otherwise. That is to say that the normalization of the discount rate relative to the Fed funds target is likely understood as a necessary pre-condition for an eventual rate hike.

US money market rates are already experiencing upward pressure. The FOMC statement reiterated its concern that bank credit is continuing to contract. The Fed needs to be careful that the market does not tighten for it.

The continued normalization of US liquidity management is a prelude to the normalization of monetary policy. It appears to be proceeding at a faster pace that the ECB, BOE and BOJ. The discount rate hike might it and of itself not do much for the dollar, but what does underscore the direction the Fed is moving. One of the next steps, probably in Q2, is to modify the FOMC statement's language to allow for greater degrees of freedom.