Federal Reserve Makes Technical Adjustment to Discount Rate

The 0.25-percentage-point upward adjustment to the discount rate spread over the federal funds is for practical purposes simply a technical adjustment that will ultimately bring the spread back up to more normal levels near 1.00%. The discount rate spread was originally lowered to only 0.25% in response to the severity of the financial crisis that kicked off in August 2007.

From August 2007 to the end of 2008, there were a number of episodes of severe stress in the inter-bank markets, which caused inter-bank liquidity to virtually evaporate globally and LIBOR spreads to spike. The Fed lowered the discount rate spread, and encouraged banks to borrow at the discount window to alleviate severe strains in the market for short-term liquidity. In addition, the Fed introduced the TAF (term auction facility) to provide auctions of short-term liquidity directly to the banking system as a complement to the measures affecting the discount rate. Now that the liquidity crisis has been effectively over for many months, both the TAF facility and the unusually low spread of the discount rate are redundant.

While the move to raise the spread of the discount rate over federal funds should in principle be only a technical adjustment, its surprising timing in view of the relatively innocuous comment in yesterday's release of the January 27 FOMC minutes caught markets off guard, sending market bond yields up sharply even in advance of the announcement.

Thus, the surprise factor could have unintended consequences of not only pushing up market rates today and tomorrow, but also fueling speculation that the Fed is already moving on a path to tighten monetary policy earlier than previously expected, and certainly earlier than what was communicated in the press release after the meeting on January 27.

Hopefully, Chairman Ben Bernanke's testimony to Congress next week will shed some important new light on the Fed's policy intentions.