Fed Hikes Discount Rate . . . so what?

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Wall Street Journal:  Rate Rise Stirs Questions

Yahoo! Finance:  Wall Street Down on Fed Discount Rate Hike Move

MarketWatch:  Fed Looks Impatient in Wake of Discount Rate Hike

Yesterday, the Federal Reserve said it had increased the so-called Discount Rate by 25 basis points (0.25%) to 75 basis points.  That’s the rate at which banks borrow from the Federal Reserve if they’re in trouble.  As you might expect, given that connotation it’s rarely used.  The discount rate had always been an overnight loan rate, but when the credit crisis hit, the Federal Reserve extended the term to a maximum of 30 days, and when Bear Stearns blew up, it extended it to 90 days.  Back in November 2009, the Fed announced it would be reducing the term to 28 days beginning January 14, 2010.  Last week, Chairman Bernanke, in testimony to the American Grandstand (i.e. Congress), said that

“before long, we expect to consider a modest increase in the spread between the discount rate and the target federal funds rate.”

There appears to be a trend here (toward normalization), the path of which seems clear, and there is an attempt to prepare markets for the news.  Yet David Kotok of Cumberland Advisors, a very sharp chap, claims it was a surprise.  (You can sign up for his equally-sharp periodic e-mail by clicking here.)  As the small sample of headlines above indicates, the action has raised a number of issues in addition to being a complete shock.

Here’s a look at the Bloomberg terminal’s Top Stories from late last night.

The credit markets have healed–as measured by corporate bond spreads and other measures–so there’s really no need for crisis measures on the monetary policy front.  That seems to have been the goal of this latest move, as the various measures are brought back to pre-crisis level.

So what’s all the worry about? 

Stocks fell because of the fear of higher rates. 

To review, higher rates are bad for stocks because:

  1. The present value of future cashflows is reduced, making company valuations lower
  2. Bonds become marginally more attractive than stocks as an alternative investment as their relative return improves
  3. Higher interest rates slow growth

Studies have shown that stocks perform worse in the rising rate regime.  That is, dividing the regimes like this:  1) the first rate hike occurs; 2) the second rate cut occurs, and looking at the returns of stocks in the two periods produces returns that are far better in regime #2.  Most of those studies look at the Federal Funds rate, which was not affected with this move.  In fact, the Fed went to some lengths to insist that this was not a precursor to a general rate hike–a tightening of monetary policy.

Treasuries (i.e. bonds) fell because higher interest rates make existing bonds worth less.

The dollar rose because higher interest rates mean higher returns on investments in the U.S.  So, again, at the margin, a foreign central bank with foreign currency to recycle just found a marginal improvement in the rate paid on investments in the U.S., for which dollars are required.

The only problem is that this decision doesn’t mean interest rates–an awfully broad term–are going anywhere soon.  The discount rate isn’t the basis for any other loans, whereas the Federal Funds rate is.

Here are the drivers of interest rates (green = lower to no change; black = neutral; red = higher rates):

  • Inflation – not a problem
  • Default/credit risk – coming down
  • Demand for credit – none yet
  • Investment demand - bonds could become a safe-haven if stocks get much choppier
  • Federal Reserve bias – “the modifications are not expected to lead to tighter financial conditions”

We don’t think the Federal Fund rate will be raised for some time for the following reasons:

  1. Inflation will not be a problem for quite a while
  2. There is a lot of slack in the system, both in capital and labor
  3. The recovery is extraordinarily fragile
  4. The unemployment rate is stubbornly high

Market participants generally agree with us as the chart of Fed Fund Futures shows.

In 1993, a Stanford economist, John Taylor devised an equation for setting monetary policy rates.  Not surprisingly, the equation has been called the Taylor Rule.  It looks like this.

What it means is that the benchmark rate should be set as a function of interest rates and slack in the economy, the latter measured as the difference between actual and potential GDP.  That slack is often referred to as the “output gap.”

Now, here’s a look at what the Taylor Rule suggests the current rate should be.

The trend in the Taylor Rule is up, but from a very low level.  It suggests the Fed Funds rate should be a minus (-)1.45%.


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