Friday, February 19, 2010

Fed Sends a Message With Discount Rate Hike

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

The U.S. Fed raised its discount rate after the market close on Thursday, February 18th. The rise in rates from 0.50% to 0.75% was characterized by the central bank as further normalization of the Fed's lending facilities. While the Fed's discount rate action is mostly symbolic, it raises the question of when the historically ultra-low fed funds rate will be normalized. As would be expected, the U.S. dollar rallied and gold sold down on the news.

The discount rate is not an important factor in control of money supply, but is the Fed's mechanism for getting money to banks when they are in crisis, either individually or because of a systemic shock. During the Credit Crisis the Fed created a number of new programs to temporarily accomplish this goal. Five of those programs were ended on February 1st. Another one, the TAF (Term Auction Facility), will have its final auction on March 8th. Prior to the Credit Crisis, the discount rate was usually a full percentage point above the fed funds rate. Even with the recent rise, it is only half to three-quarters point higher. We are still not yet back to the way things were pre-Credit Crisis. Fed Chair Bernanke has been saying the U.S. banking system was fixed for many months now. If that is the case, why has he waited so long to get the Fed's operations back to the way they have been historically when there is no crisis?

The last time the Fed began a major policy change was with a move in the discount rate. The Fed first cut this rate by 50 basis points in August 2007. One month later, it started lowering the fed funds rate and continued doing so until instituting its current zero to 0.25% rate policy in December 2008. While Bernanke's signature approach is to change the discount rate first, the time lag is likely to be longer than one month this time. Members of the Open Market Committe may already be losing their patience for ultra-low rates however. The Kansas City Fed Governor dissented at the January meeting on the fed's message of "exceptionally low levels of fed funds rates for an extended period". He wanted language that indicated something briefer.

Higher U.S. interest rates are of course bullish for the dollar. Although the U.S. will have to raise rates by 0.50% to be higher than Great Britain's rates, by 1.00% to outdo the euro zone, and by 3.75% to challenge Australian rates. The U.S. trade-weighted dollar continued its rally on the Fed news and is flirting with nine-month highs. The euro on the other hand fell as low as 1.3443 on the news. Technically, the dollar confirmed its rally with the 50-day moving average moving above the 200-day - a classic buy signal.  The euro has the opposite chart pattern and the 50-day average having dropped below the 200-day earlier this month. Gold held up better than expected. February is a month of strong seasonal buying for the metal and this has provided enough buying pressure to prevent significant drops for now.

Disclosure: No positions.

NEXT: Greece's Statistical Lies - Are the Numbers Any Better in the U.S.?

Daryl Montgomery
Organizer, New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.


Spodeworld said...

Daryl - Do you see any implications for gold with this decision?

g-money said...

I think it's good news but that's just me.