Focus On The Fed

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Fed Rate Move Rattles Stocks and Sends Dollar Higher
By SEWELL CHAN
February 20, 2010

WASHINGTON — The Federal Reserve’s decision to raise the interest rate it charges on short-term loans to banks reverberated in the financial markets Friday, sending overseas stock indexes lower and giving fresh momentum to a recent rise in the dollar.

The Fed took the move to normalize lending after holding interest rates to extraordinary lows for more than a year to prop up the financial system. But the decision, announced after the close of equities markets in New York, sent Asian shares lower, with the Nikkei 225 index in Tokyo dropping nearly 2 percent, and both the Kospi index in Seoul and the Hong Kong’s Hang Seng indexes showing similar declines.

The reaction in Europe, however, was much more muted, with the major indexes in Frankfurt, London and Paris regaining lost ground in afternoon trading. The CAC-40 in Paris, which earlier had declined about 1 percent, was down 0.41 percent. Wall Street, which is more than 2 percent for the week, is also expected to open lower.

The move also helped propel the dollar’s recent rise even further, reaching $1.35 to the Euro, its strongest level against that currency in nine months.

While the central bank had signaled its intentions to take such a step, the timing was a surprise. The announcement was made in a carefully worded statement that emphasized that the Fed was not yet ready to begin a broad tightening of credit that would affect businesses and consumers as they struggle to recover from the economic crisis.

But while the move will not directly affect home mortgage, credit card or auto loan rates, it was a clear sign to the markets, politicians in Washington and the country as a whole that the era of extraordinarily cheap money necessitated by the crisis was drawing gradually to a close.

The Fed’s board of governors raised the discount rate on loans made directly to banks by a quarter of a percentage point, to 0.75 percent from 0.50 percent, effective Friday.

It also took two steps to begin unwinding its efforts to keep the banking system functioning after the real estate bubble inflicted huge losses that were amplified by sophisticated bets made by Wall Street.

Given the slow and uneven nature of the recovery, an unemployment rate close to 10 percent and fears of a new wave of mortgage defaults, particularly in commercial real estate, few economists expect the Fed to begin a campaign of broader interest rate increases quickly or sharply. The central bank reaffirmed last month that the key short-term interest rate it controls would remain “exceptionally low” for an “extended period,” language it has used since March.

While borrowing by banks from the Fed’s discount window has already fallen to more historically normal levels from its peak in October 2008, many small and medium-size businesses still find it difficult to obtain loans, a major concern of the Obama administration and Congress.

Randall S. Kroszner, an economist at the Booth School of Business at the University of Chicago and a former Fed governor, said after the announcement: “This is a technical change that makes sense as a precondition for other changes, but is not a precursor of short-term change.”

Having taken a baby step toward a return to normalcy, the Fed’s chairman, Ben S. Bernanke, now faces a delicate dance in the months ahead.

The central bank will try to drain from the financial system some of the money it created to keep banks and the economy afloat over the last two years. And at some point it will begin putting upward pressure on interest rates by raising its benchmark fed funds rate, the rate at which banks lend to each other overnight.

Uncertainty surrounds the timing and sequence of those steps. Mr. Bernanke is scheduled to present the Fed’s semiannual monetary policy report to the House on Wednesday and the Senate on Thursday — testimony the markets will watch closely.

As part of the changes disclosed Thursday, the Fed announced that the typical maximum maturity for primary credit loans, in which banks borrow from the discount window, would be shortened to overnight, from 28 days, starting March 18.

The Fed also raised the minimum bid rate for its term auction facility — a temporary program started in December 2007 to ease short-term lending — to 0.50 percent from 0.25 percent.

The central bank took pains to reiterate that it was not moving in a sudden new direction.

“The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy,” the Fed said in its statement.

Despite that attempt at reassurance, there were some early signs after the announcement that investors were already beginning to anticipate broader interest rate increases. Stock futures fell in after-hours trading; yields on 10-year Treasury notes rose about seven basis points, or seven-hundredths of a percentage point, to 3.8 percent.

The discount rate applies to loans the Fed makes for very short terms, to sound depository institutions, as a backup source of financing.

The Fed’s action represents a widening of the spread between the discount rate and the upper end of the target fed funds rate. The two rates typically move in lockstep, and were a percentage point apart before the crisis.

In an effort to encourage banks to come to it for funds to maintain their stability during the crisis, the Fed sought to make borrowing from the discount window more attractive than usual — and to reduce the stigma associated with borrowing from the Fed. As the fed funds rate went as low as it could go, the Fed reduced the spread between the two rates to half a percentage point in August 2007 and then to a quarter point in March 2008.

When the target range for the fed funds rate was lowered to zero to 0.25 percent in December 2008, the discount rate dropped to 0.50 percent, its lowest level since World War II.

In testimony Mr. Bernanke submitted to Congress on Feb. 10, he said that “before long, we expect to consider a modest increase in the spread” between the two rates.

And on Wednesday, the Fed released minutes from the discussion of its main policy-making arm, the Federal Open Market Committee, at its last meeting, on Jan. 26-27. Those minutes showed a consensus that it would “soon be appropriate” to begin widening the spread.

Laurence H. Meyer, a former Fed governor who runs a consulting firm, Macroeconomic Advisers, said the Fed had done its best to send clear signals.

“If the markets respond to this on Friday, it will reflect a total lack of comprehension of what the chairman said,” Mr. Meyer said. “Don’t they understand the meaning of soon?”

The Fed said banks should use the discount window “only as a backup source of funds.”

And it left open the possibility of widening the spread further in the future, saying it “will assess over time whether further increases in the spread are appropriate in view of experience” with the new half-point spread.

While liquidity for banks has been nursed back to health, many other sectors remain in a parlous state.

Dennis P. Lockhart, president of the Federal Reserve Bank of Atlanta, said after the announcement that along with the increase in the discount rate and the phasing out of special loan programs, the Fed would complete its purchase of $1.25 trillion in mortgage-backed securities by the end of March.

“All of this is happening because stress in the financial system has abated,” he told the Augusta Metro Chamber of Commerce in Georgia.

He added: “My point is that the public and markets should not misinterpret today’s move. Monetary policy, as evidenced by the fed funds rate target, remains accommodative. This stance is necessary to support a recovery that is in an early stage and, in my view, still fragile.”

Bettina Wassener contributed reporting from Hong Kong.

http://www.nytimes.com/2010/02/20/business/20fed.html?ref=business&pagewanted=print