Friday, February 19, 2010

What Does The Fed's Discount Rate Increase Mean?

So the Fed unexpectedly decided to raise the discount rate. What implications will this have?

The direct effect is neglible. The discount window is used so rarely that a discount rate increase won't have any effect on real world interest rates worth mentioning.

However, as the market reaction illustrates, this increase will have the indirect effect of increasing expectations that the Fed will increase the rates that really matter -the Fed funds rate and the interest that the Fed pays on bank reserves- sooner rather than later.

While the Fed claims that this is meant to normalize the spread between the funds rate and the discount rate, and that they intend to keep the funds rate low for an extended period, and while this may actually be true, many people will nevertheless interpret this as a signal that the more important rates will be raised sooner than people earlier thought, something which will increase bond yields, and thus have a tightening/deflationary effect. The effect will however probably only be very small.