Fed hikes discount rate, says loose policy to stay

The Fed cast its decision to raise the discount rate it charges banks by 25 basis points to 0.75 percent as a response to improved market conditions that allowed it to scale back emergency aid for financial institutions.

It took pains to distinguish its efforts to foster market liquidity from monetary policy and to draw the distinction between the discount rate and its main federal funds rate, which remains near zero to help a fragile U.S. economic recovery. Fed officials also insisted the move that takes effect on Friday was not a sign that a policy tightening was forthcoming.

They do not signal any change in the outlook for monetary policy and are not expected to lead to tighter financial conditions for households and businesses, Fed Governor Elizabeth Duke said in an address, echoing the Fed statement.

Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, loose monetary policy was still the order of the day.

Monetary policy -- as evidenced by the fed funds rate target -- remains accommodative, Lockhart said in a speech.

This stance is necessary to support a recovery that is in an early stage and, in my view, still fragile.

The move was flagged by Fed Chairman Ben Bernanke last week, but its timing - well ahead of the March 16 policy meeting -- surprised markets and convinced investors the Fed moved one step closer to lifting its benchmark rate.

RETURN TO NORMAL

The Fed can talk all day about how the discount rate hike is technical and not a policy move, but the market sees it as a shot across the bow, said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ in New York.

The U.S. dollar climbed to a nine-month high against the euro, while U.S. stock futures and government bond prices fell after the announcement.

Interest rate futures markets moved to price in about a 70 percent chance of a rise in the Fed's main policy rate, the federal funds rate, by late September, up from 54 percent.

This is a significant and likely symbolic move that will impact on market sentiment, Robert Rennie, a strategist at Westpac in Sydney said in Reuters Dealing Room.

The emergency easing cycle began with discount rate cuts - it was all about easing liquidity to banks. So the move to raise the discount rate means the long journey toward normalisation has begun.

The dollar pared gains and treasury futures trimmed losses, however, after another Fed policymaker, James Bullard, warned market expectations of a rise in the Fed's benchmark rate were overblown. St. Louis Federal Reserve Bank President Bullard is a voter on the Fed's interest rate-setting panel this year.

Before the financial crisis erupted in 2007, the discount rate was typically a full percentage point above the federal funds rate. The Fed's decision on Thursday begins to move it back nearer its traditional premium and it said it would assess over time whether it needed to further widen the spread between the discount rate and the federal funds rate.

The Fed halved the spread between the two rates in August 2007, when it cut the discount rate by a half-percentage point in a first attempt at taming the credit crisis. It narrowed the spread to just a quarter point in March 2008.

Both of those cuts, like Thursday's hike, came outside of the Fed's scheduled meetings, where decisions on the federal funds rate are taken. The increase in the discount rate was the first rise in either rate since June 2006.

ECONOMIC OUTLOOK UNCHANGED

The central bank's view of the economy has brightened in recent months as job losses eased, consumer spending strengthened and businesses stepped up purchases of equipment and software. Still, the Fed has warned that recovery from the deepest U.S. recession since the 1930s will probably be sluggish and has said it expects to keep the federal funds rate near zero, where it has been since December 2008, for an extended period.

In its statement on Thursday, it said the economic and policy outlook remained broadly unchanged from late January, when its policy committee reiterated that low-rate pledge.

Some other central banks around the world have begun to tighten policy. Australia led the way last year and its central bank chief signaled on Friday more rate increases in months ahead while China took several steps to curb bank lending.

In the United States, however, the Fed has said extraordinarily low interest rates are still warranted with the unemployment rate near 10 percent.

I don't think the Fed dares (to) increase the fed funds or policy rate in the face of unemployment at double-digit type of levels, Bill Gross, the manager of Pimco, the world's biggest bond fund, told Reuters after the Fed announcement.

Reuters Insider: http://link.reuters.com/mep22j

Other changes announced on Thursday included shortening the typical maximum maturity for primary credit loans to overnight from 28 days, effective March 18, and raising the minimum bid rate for the Fed's Term Auction Facility, another program put in place to foster market liquidity.

(Additional reporting by Jennifer Ablan and Daniel Burns in New York; Writing by Tim Ahmann and Tomasz Janowski; Editing by Dayan Candappa)