Markets decide Fed’s discount rate increase is no big thing

The financial markets have bought it.

The Federal Reserve’s move to increase the discount rate, the interest rate it charges banks to borrow money overnight, by 0.25 percentage points to 0.75% is part of “normalization” after the financial crisis and not a sign that the U.S. central bank is about to start raising its benchmark interest rate.

That’s how Fed chairman Ben Bernanke pitched the change. The U.S. financial system has recovered enough, he said, so that the Fed can begin with withdraw some of the support it offered during the crisis. In normal times the Fed sets its discount rate about 1 percentage point higher than its benchmark short-term rate now at 0% to 0.25%. The increase announced on Thursday, February 18, after the stock market had closed is merely part of a return to normal. So too is the end of an extension of overnight loans from the Fed to banks to as much as 30 days. Overnight loans will go back to being just overnight.

The financial markets, of course, didn’t have to buy into this interpretation.

Stocks on Friday, in fact, initially traded as if investors feared that the increase in the discount rate was indeed a signal that the Fed had changed policy and was going to move quickly to raise its benchmark interest rate.

But by the end of the day Bernanke’s framing of the move had prevailed and market commentary was stressing that the change was no big deal. By the weekend sentiment had moved even further and now the increase in the discount rate is being seen as a sign of strength in the U.S. economy and not as the first of a series of interest rate increases that would jeopardize the U.S. recovery.

It certainly helped that core consumer inflation for January fell by 0.1%. That reassured investors that the Federal Reserve wouldn’t need to increase interest rates soon to head off inflation.

This morning, Monday, February 22, Asian markets and oil both rose signaling a belief that the Fed isn’t about to increase interest rates and that Fed chairman Bernanke will repeat his pledge in testimony to Congress on Wednesday, February 24, that the Fed will keep interest rates at current low levels for an extended period of time.

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6 comments

• EdMcGon on 22 February 2010

  Jim,
  I have to agree with the markets assessment on this. There’s plenty out there in the economy to worry about. The Fed’s move on this ain’t it.
• sliman on 22 February 2010

  The Fed will be late to raise interest rates as usual. Inflation will turn up.
• BenWobbles on 22 February 2010

  Jim,

  Any thoughts on DGW from watch list after today’s big drop?

  Thanks!
• chapmame on 22 February 2010

  I am interested about DGW as well… I couldn’t find a reason for the big drop, unless the secondary stock offering didn’t go well. Anyone else find information on this?
• phantomrio on 22 February 2010

  If I understand correctly, consumer core inflation excludes food and energy. These two categories together with medical related expenses constitute a large portion of many consumers’ budgets. So why are big ticket items, such as autos, considered to be more positive indicators of low inflation?
• ripper on 22 February 2010

  Jim,
  They had someone on CNBC talking about gas (well all energy) being over inflated due to rates staying so low.
  What is you take on that?