The Federal Reserve's Discount Rate Hike: Are Market Forces Returning?

After the stock market closed today, the Federal Reserve announced that it was raising the discount rate by 0.25%, from 0.5% to 0.75%. This increase has little direct impact on the banking system, since banks rarely borrow from the Fed's discount window. But it may be a momentous signal. Since the fall of 2008, the Fed has been in total crisis management mode, with nary an accommodation that was too extreme to provide to the financial markets. It virtually gave away credit to banks and other financial institutions in an effort to prevent panic. And, last year, even while the stock market zoomed upwards some 60%, the Fed still aimed to serve and please the banking system with every imaginable amenity. As recently as last month, it still anticipated maintaining "exceptionally low levels of the fed funds rate for an extended period."

But today's announcement was made in between Open Market Committee meetings, when rate decisions are normally made. The most recent meeting was Jan. 26-27, 2010, and the next one is March 16, 2010. Rate changes in between meetings are unusual, and can be interpreted to mean that we aren't in a business as usual mode. Although a Fed governor was quoted by news services this evening as saying that the discount rate hike isn't meant to "signal any change in the outlook for monetary policy" and is just "further normalization of the Federal Reserve's lending facilities," the markets had the opposite take. The dollar jumped in afterhours trading, as did short term U.S. interest rates. Asian markets opened to the downside and overnight trading in U.S. stock index futures moved downward as well. The markets sense a shift in the wind.

The most likely reason for today's out of the ordinary rate hike was the Producer Price Index report this morning, which revealed that the PPI jumped 1.4% last month. On an annualized basis, that would be close to 17%. No one expects inflation this year to be anywhere near 17%, but any suggestion that inflation would be more than very low would put the Fed under pressure to raise rates. The Fed has pumped an extraordinary amount of liquidity into the financial system in the last year and a half, and, if inflation flares up, this heap of liquidity would be like dry tinder in a forest after a drought.

Stocks today ignored the PPI report, with the Dow Jones Industrial Average rising 83 points. That probably was because the Fed has seemed so nonchalant about inflation risk. But clearly something has happened in the minds of the Fed governors, something that was quite opaque until today's discount rate hike after the market closed. It may well be the higher risk of inflation that today's PPI report revealed. It might also involve China. The Chinese central bank has been raising the interest rate it pays on bank reserves, a measure designed to reduce liquidity in the banking system and cooling off the bubbly real estate and credit markets, and rising inflation, in China. Because China continues to informally link the yuan to the dollar, excessive liquidity pumped out by the Fed could spill over into China and counteract what the Chinese central bank wants to accomplish. America needs Chinese as a source of credit for its massive federal deficits, and the Fed probably wants to stay on good terms with its Chinese counterparts.

The Consumer Price Index for January 2010 will be announced tomorrow (Friday, Feb. 19, 2010) morning, before the stock market opens. You can bet that traders will be much more focused than yesterday on the announcement. And there are probably good odds that the CPI will be uglier than people anticipated yesterday. The high PPI was driven by an unusually large jump in gasoline prices (5.1%) and an 0.4% increase in food prices. Gasoline and food would have significant impact on the CPI. Light truck prices as included in the PPI rose 1.9%, and would also impact the CPI, as light trucks continue to be half or more of the automotive market.

If the CPI number is bad, you can expect short term interest rates to edge higher. Although a sizeable increase isn't likely until the Fed allows the fed funds rate to rise, the markets can no longer assume the cheapest of all imaginable government-subsidized credit. As interest rates rise, the costs of speculation rise, since interest charges and repayment obligations are a certainty. But profits aren't. It begins to make less sense to dive into high risk derivatives and commodities bets, even if they offer potentially high returns. Market forces forced into the wood work by the Fed's zero percent interest rate policies may now emerge. Money managers and speculators might have to re-evaluate and perhaps retrench. Stock prices could go wobbly.

But the potentially good news is that money no longer deployed in financial speculation could wend its way into the real economy. Businesses starting to see upturns in order flow may find banks a little more willing to lend to them. Most small businesses can't compete for credit with Wall Street speculators betting on asset prices bubbling up in a zero percent interest rate environment. But add an element of risk to speculation, and lenders may begin to see the attraction of lending to businesses with orders in hand.