The Federal Reserve 25 basis point increase in the discount rate last Thursday to 0.75% was not a market moving event. Bond and mortgage rates were unaffected and banks whose Fed borrowing is directly subject to it hardly noticed; primarily because none of them are borrowing from the Fed. If there is no effect why do it?
Historically the discount rate has been about 1% over the federal funds rate; essentially it is a penalty charge for a bank's inability to access the private money markets. With fed funds at 00%-0.25% the discount rate probably has two more 25 basis point hikes in the immediate future. The Fed itself said the increase represented a 'normalization' of lending rather than a change in policy. For more than a year the FOMC statement has included its assessment of the US economy as needing low rates for an extended period. Fed officials repeated that judgment on Thursday.
If the increase in the discount rate is a measure of Ben Bernanke's desire to return to normal interest rate policy, it is also a sign of his inability to do so.
Banks and the banking system are no longer on the front lines of distress. If they were or if the government still had serious concerns about their capital or asset structure the Fed would not have risked even this symbolic step. If the reported profits and bonuses of some of the banks that took government TARP money are one sign of returned corporate health, this rate increase is a second.
Consumer inflation, headline and core, is benign. In January CPI gained 0.2% and the core measure was negative at -0.1%. The year over year readings were 2.6% and 1.6% respectively. This was the first monthly fall in core inflation since December 1982. It has long been the Fed contention that inflation would be restrained by the recessionary inability of firms to raise prices and the deflationary effect of unemployment on wages.
But inflationary indicators are stirring. In January the Producer Price Index (PPI) gained 1.4%, almost double the expectation and more than three times the December reading of 0.4%. The yearly reading was 4.6%; in December it was 4.4%. Over the past six months the rate of wholesale inflation has been 9.8%. The Fed may be correct that firms are currently unable to pass along price increases. But PPI seems to indicate building inflationary pressures that even a modest decrease in the unemployment rate may remit into consumer and wage inflation.
The Fed's main concern is jobs. Its estimated range for GDP growth this year of 2.8% to 3.5% will not reduce unemployment. The recent up tick in weekly jobless claims, the four week moving average has gained almost 27,000 in the New Year, is a warning on the complete lack of job creation.
The Fed cannot yet make a substantive rate move in the face of a very weak job economy and uncertain prospects for long term employment growth, even though rates have been effectively held at zero for more than a year. At the same time Mr. Bernanke does not want traders, especially bond traders to think that he is ignoring the inflationary potential of the huge increase in the money supply from the emergency liquidity measures of the past two years.
In addition, the imminent end of the Fed's Mortgage Backed Securities (MBS) purchase program could have a serious negative impact on mortgage rates and on the housing market; just about the last thing the Fed wants now is a spike in mortgage rates.
Housing is directly tied to the health of the banks, the stability of the financial system and the wealth of the consumer economy. Many institutions still hold large amounts of asset-backed paper with questionable mortgage portions. The housing market remains weak; most measures are close to historic lows and consumers are already severely constrained in their spending by their lack of housing equity.
If the withdrawal of Federal support for the housing securitization market causes a rise in mortgage rates, then the entire cycle of falling housing prices devaluing the existing mortgage assets on bank books, requiring more support capital, the cycle that almost brought down the system last fall, could reignite. And if consumers see the value of their homes starting again to fall consumption will plummet.
The actual vulnerability of the financial sector is considerably less than it was in the fall of 2008 because some of the mark-to-market rules on asset valuation have been relaxed. Banks no longer have to price assets for which there is no market reference well below residual value. Still, after the 2008 near death experience, Ben Bernanke and the Fed Governors will take no chances.
In the American economic environment of low but potential inflation, weak GDP growth, nonexistent job creation, a moribund and still dangerous housing market, a financial sector in remission and constrained consumer spending, the placebo of the discount rate is all the anti-inflation medicine the Fed can afford to prescribe.