Posts Tagged ‘discount rate’

What does Discount Rate hike mean to you?

Saturday, February 20th, 2010

Definitions:  Discount rate is the “penalty rate” for banks needing emergency funds from the Federal Reserve (normally around 1% higher than the Fed Funds Rate).  Fed Funds Rate is the interest rate at which banks lend their balances (known as federal funds) held at the Federal Reserve to other banks, usually overnight.  The Discount Rate is set by the Fed Board of Governors, and the Fed Funds Rate is set by the Federal Open Market Committee (FOMC).

Last week the Fed’s Board of Governors raised the Discount Rate from 0.5% to 0.75% inter-meeting.  The surprise was not the amount, but the timing.  Two weeks ago, Bernanke’s prepared text to Congress stated the intent to raise the Discount Rate soon (defined normally as “in the future”, and market didn’t really appreciate that would be in 7 days).  The Fed also reduced the length on discount window borrows to the normal overnight term (since the Fall of 2008 the term had been extended to 28 days).  Currently, only $14.9 billion of window borrowing is outstanding, compared with over $1 trillion of cash held in Federal Reserve funds.  The Dow Jones rallied 233 points with the first discount rate decrease (Aug 2007), and markets declined with the discount rate increase.  The effect on the economy, bank lending and non-bank company profitability has nothing to do with the discount rate over the long-term.  It took increasing the Fed’s balance sheet to almost $2 trillion to arrest the downward spiral in the economy and markets (current financial crisis was a credit crisis, not a liquidity crisis, so reducing Fed Funds Rate and Discount Rate had a negligible effect on arresting the downward spiral).

For months, the Fed has written and talked extensively about exiting from the various strategies used to stabilize the financial markets.   The raising of the discount rate means the exiting has started, even if done gradually.  Markets of any kind really dislike uncertainty.  The inter-meeting change created uncertainty about the market pricing of all financial assets.  Interest rates, foreign exchange rates, and implied volatility of all assets have now been priced into the market.  This is reflected in an uncertainty premium.  The dollar has strengthened and solidified it’s strong trend relative to the Euro, Pound and commodity exporting countries.

Bottom Line:  1) Uncertainty is now firmly entrenched into the markets, 2) Investors need to be very clear on the timeline of their investments – short-term, intermediate and long-term – and the acceptable level of uncertainty on those investments, and 3) Looking at over 200 years of financial and economic history, this is a normal process.

Always Asking, Never Assuming™

Christopher Holtby

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Inflation debate information

Friday, January 15th, 2010

As you probably aware, by March 31, 2010, the US Federal Reserve will have completed the purchase of $1.25 trillion of federal agency mortgage paper from Fannie, Freddie and broker-dealers.  The mechanics of this process starts with the Fed printing money and paying this newly minted money to the sellers of the mortgage paper.  When the sellers are private companies, such as banks, this can cause the money supply and monetary base in the US to rise significantly.  The banks can choose to invest, lend or deposit the funds at the Federal Reserve in an interest bearing account.  Because the velocity of money has not increased (as of 1/15/10), this means that, so far, the banks, constrained by current or future loan problems, have deposited the sales proceeds at the Federal Reserve.  Currently, analysts do not know exactly how much of the mortgage paper was sold by banks versus Fannie and Freddie, which makes the analysis more difficult.  These details will not be available for another few months.

As long as these deposited reserves remain at the Fed, the monetary base has increased, but the money multiplier has not started ($1 of reserves can be leveraged around 10x).  The worry for all investors is: when and why will the banks move money from their Fed interest bearing accounts and lend and/or invest the money for a higher rate of return?  This would increase the money multiplier and eventually cause inflation. Right now, the largest part of the Fed’s balance sheet is comprised of GSE-based residential mortgages.  The great debate centers around the how to “unwind” or “exit” the program of holding GSE-based residential mortgages.  If the Fed signals they will begin to sell, these securities will drop in value very quickly in anticipation of the largest owner of these securities coming to market.  That is not a good option.  The Fed could just hold the mortgages until maturity, but that would cause another set of problems.  The Fed could completely stop purchasing mortgage bonds from Fannie and Freddie.  In essence, the Fed is trapped, as all options have less than perfect outcomes.

The Fed can increase the reserve deposit rates offered to banks holding deposits there at any time.  The Fed could raise those reserve deposit rates if they feel banks are beginning to loan or invest those original mortgage paper proceeds.  They can also engage in term deposit auctions of bank’s deposits at the Fed, thus “locking in” money and avoiding this money leaking into the economy.  These actions do not withdraw liquidity from the banking system as asset sales would; they only temporarily limit the effects of the money multiplier.  It appears likely the Fed can manipulate and extend this system for quite some time.

Bottom line:  This is a complicated topic.  Investors should pay attention to the reserve deposit rate, as well as other policy interest rates.  The inflation debate centers on more than just the increase of the Fed’s balance sheet.

Always Asking, Never Assuming™

Christopher Holtby

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