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What to make of the Fed’s Recent Interest Rate Hike

The Federal Reserve surprised virtually everyone after the markets closed yesterday by announcing their intentions to raise the Discount Rate by 0.25% (i.e. 25 Basis Points) from 0.50% to 0.75%.  This marks the first time that the Federal Reserve has raised the Discount Rate since June of 2006.

Perhaps more importantly, the Federal Reserve also curtailed the duration of the loans from the “discount window” from 28 days to overnight.  So what does this recent action suggest about the direction of interest rates and the status of the economic recovery? Let’s examine each these two interrelated areas separately.

The Discount Rate is the interest rate the Federal Reserve charges to commercial banks and other depository institutions from the discount window at the Federal Reserve. These loans are generally short term, emergency loans.  This rate historically has ranged between 0.25% – 0.50% above the more recognized Federal Funds Rate. It is the Federal Funds Rate, which many other rates of credit rely upon for direction that has more of a direct impact on the U.S. economy as the Federal Funds Rate which is the interest rate at which depository institutions lend their balances at the Federal Reserve to other depository institutions. Through their open market operations that Fed attempts to implement their current monetary policy towards an intended Federal Funds Rate. This rate was not part of the recent Federal Reserve action although many individual investors probably thought that it was and remain confused by the distinction between the two interest rates. While the increase in the Discount Rate does not guarantee an increase in the Federal Funds Rate, and the Federal Reserve even suggested in an accompanying statement their move will not necessarily lead to a change in monetary policy through adjustments in the intended Federal Funds Rate, history suggests that it is almost a foregone conclusion and given that the Federal Funds Rate is currently close to 0%, it is reasonable to suggest that the rate certainly cannot go any lower. The question then becomes when and to what extent.

In terms of the implications of the move on the status of the U.S. economic recovery, the Federal Reserve is standing by their previous contentions that they intend to leave the Federal Funds Rate low for an extended period of time in an effort to continue to try to stimulate a struggling U.S. economy. While this may be accurate, we, at Hennion & Walsh, also believe that the Federal Reserve recognizes the imposing threat of inflation and perceive this as a first step along a longer-term, measured exit strategy with the ultimate goal of returning the credit markets to a more normal state of operations.

While the market generally does not like surprises, this one may very well have been a welcomed one.