Fed Hikes Rates, But Which One?

Last week, the US Federal Reserve dropped a bombshell on the markets by deciding to implement a discount rate hike, the first one since June 2006. Is this the end of the Fed’s aggressive monetary easing policies?

In a surprise move, the central bank raised the discount rate by 25 basis points, from 0.5% to 0.75% last Thursday. With most investors speculating that this hike signaled the beginning of tightening policies, they scrambled to buy up the US dollar, eventually boosting it to its nine-month high.

Although the Fed already dropped several hints about this move during the past month, the immediate price action during the Fed’s announcement revealed that most market participants took the discount rate hike as a sign that future interest rate hikes are on the horizon.

Hold on a second. Discount rate and interest rate… What’s the big difference? Let me explain my young padawans…

The discount rate is the interest rate at which the Fed charges banks and other financial institutions that borrow reserves from it. Take note that the discount rate, which is usually higher than the federal funds rate, is dictated and set by the Fed.

On the other hand, the federal funds rate, sometimes called the benchmark interest rate, is the interest rate at which financial institutions such as commercial banks lend to each other. Unlike the discount rate, the federal funds rate is simply a guideline, and banks can choose not to comply.

According to the Fed’s top cowboy Ben Bernanke, the bank’s move to raise its discount rate was not an indication that it would soon hike its benchmark interest rate as well. In his statement, he said that the decision to do so is “not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signaling any change in the outlook for monetary policy.” He added that the action was mainly done to “normalize” Fed lending. By adjusting the discount rate, financial institutions will be encouraged to rely more on the money market rather than on the central bank.

He went on further by saying that the bank’s interest rate will be at a low level for an “extended period.” Still, it isn’t surprising at all that they still flooded the markets with dovish statements even after raising the discount rate. After all, the Fed has been standing on a “wait and see” approach the past few months. Some economists, however, think that while the bank is not mulling over an interest rate hike soon, the bank is already preparing for such whenever the US’s economic situation warrants it.

Before the bank implements any more policy changes, they will probably have to wait for more signs of recovery. One indicator that shouldn’t be overlooked is inflation. Last Friday, CPI data was released, printing that core CPI figures fell by 0.1% last month. This indicates that inflation remains subdued, as it has for the past year. As long as inflation remains low, this gives the Fed room to keep interest rates at low levels.

On Wednesday, Bernanke will testify before the Financial Services Committee regarding the US’s present economic state, outlook, and of course, the bank’s recent move. Now, looking at my forex crystal ball, I can somewhat see him uttering his usual tag-line, “we will probably see interest rates stay at low levels for an “extended period.”” Ha!