Fed Raises Discount Rate: Interest Rate Rises For Banks' Emergency Loans

Posted: Updated:

WASHINGTON — The Federal Reserve decided Thursday to boost the rate banks pay for emergency loans. The action is part of a broader move to pull back the extraordinary aid it provided to fight the financial crisis.

The action won't directly affect borrowing costs for millions of Americans. But with the worst of the crisis over, it brings the Fed's main crisis lending program closer to normal.

The Fed chose to bump up the so-called "discount" lending rate by one-quarter point to 0.75 percent. It takes effect Friday.

The central bank said the step should not be seen as a signal that it will soon boost interest rates for consumers and businesses. It repeated its pledge to keep such rates at record-low levels for an "extended period" to foster the economic recovery.

The Fed had signaled for weeks that a higher discount rate was coming, though the timing of Thursday's decision caught some by surprise. It portrayed its action as moving its emergency program for banks closer to normal.

The announcement came after the financial markets had closed. Investors saw it initially as a prelude to higher borrowing costs across the board. In after-hours trading, the dollar strengthened on the expectation of higher rates. Yields on two-year Treasury securities rose, and stock futures dipped.

After the sell-off in stock futures, Pimco Managing Director Bill Gross warned investors not to overreact.

"I'd accept the Fed at its word – that this isn't a change in monetary policy or in the timing of it," he said. "Calmer heads may prevail tomorrow."

T.J. Marta, a market strategist, said he thinks higher rates for American borrowers are still months away. But "I think one man's normalization is another man's tightening," he said of investors' initial anxiety.

The Fed has kept the target range for its main interest rate – the federal funds rate – at between zero and 0.25 percent since December 2008.

After the Fed's action Thursday, economists said they still believe it won't start to boost borrowing costs for Americans until later this year. Some don't think it will happen until next year, given the fragile recovery.

Chairman Ben Bernanke last week signaled the Fed is in no rush to boost rates.

When the time does come, Bernanke said the Fed will likely start to tighten credit by raising the rate it pays banks on money they leave at the central bank. Doing so would raise rates tied to commercial banks' prime rate and affect many consumer loans. That would mark a shift away from the federal funds rate, its main lever since the 1980s.

Steering interest rates through the excess reserves rate, now at 0.25 percent, gives the Fed more control over money floating around the financial system. The Fed sets that rate directly; its funds rate is just a target.

James Paulsen, chief investment strategist at Wells Capital Management, saw the Fed's move Thursday as testament to an improving economy.

"This may be the bell ringing that the crisis is over," Paulsen said.

The big question over the next few days is whether investors will start selling Treasurys with maturities of two years or less, Paulsen said. Doing so would send yields higher. Savers would start seeing higher interest on their money market accounts.

The economy is growing again, and financial conditions have improved. But unemployment is still near double digits. And demand for loans remains weak. Many ordinary Americans and small businesses have found it difficult to borrow.

When credit virtually shut down starting in 2008, banks that wanted to borrow had nowhere to go except the Fed. Banks can now more easily tap private lending sources. As a result, the Fed feels more comfortable about boosting the rate banks pay on emergency loans.

Because conditions have improved, the Fed also said it will shorten the length of loans drawn from its emergency lending program. It will return to the historical norm of overnight loans, effective March 18. During the crisis, the Fed had lengthened the loans to 30 days.

Earlier this month, the Fed shut down a handful of programs to help banks and other companies access credit. Like those shutdowns, the action Thursday is "intended as a further normalization of the Federal Reserve's lending facilities," the Fed said.

"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 monetary policy," the Fed said.

Banks have scaled back their use of the Fed's emergency "discount" loan window as conditions have improved.

At the peak of the crisis in the fall of 2008, daily borrowing from the discount window reached $110 billion. Commercial banks averaged $14.3 billion in daily borrowing for the week that ended Wednesday, the Fed said in a report Thursday. That was down from $14.6 billion for the previous week.

Congress has demanded the Fed identify the banks that draw on the emergency loans. The Fed has resisted. Bernanke and his colleagues have argued that identifying the banks that take out emergency loans could cause a run on the institution.

Created by Congress in 1913 after a series of bank panics, the Fed acts as "lender of last resort" to banks that can't borrow elsewhere. Its actions help stabilize the financial and economic systems. And its decisions on rates affect the ability of companies and individuals to borrow and spend.

The wind-down of Fed programs earlier this month, most of which had fallen out of use, was little noticed. A bigger impact could be felt by the scheduled shut-down of the Fed's program to buy mortgage securities from Fannie Mae and Freddie Mac. That program is slated to end after March.

The purchases of mortgage securities have lowered home-loan rates and bolstered the housing market. The Fed has held the door open to extending the program if the economy weakens. Some analysts fear that once the program ends, mortgage rates could rise, hurting the recovery in housing and the overall economy. Rates on 30-year mortgages averaged 4.93 percent this week, Freddie Mac reported.

Unwinding the Fed's stimulus is the biggest challenge for Bernanke in his second term, which began Feb. 1. Moving too soon could short-circuit the recovery. Waiting too long could unleash inflation and feed a speculative asset bubble.

More insights into the Fed's strategy will likely come when Bernanke testifies on Capitol Hill next week.

David Rosenberg, chief economist at money manager Gluskin Sheff in Toronto, says the Fed's decision to bump up the emergency lending rate for banks is psychological but still packs a punch.

"The Fed is moving toward a new strategy of draining liquidity from the system," he says. "Will the Fed be raising the Fed funds rate soon? No. But what happens when it stops buying mortgages or even starts selling? That could have a material impact on mortgage rates."

___

AP Business Writers Bernard Condon and Tim Paradis in New York contributed to this report.

Around the Web

FRB: Monetary Policy, the Discount Rate

Prime Rate | Federal Funds Rates Discount Rate Fed Fund Reserve ...

Federal Discount Rate | Federal Reserve Rates

Fed Raises Interest Rate That It Charges Banks

Fed Raises Discount Rate Quarter Percentage Point

Fed Slightly More Confident, Minutes Show

US STOCKS SNAPSHOT-Futures drop on Fed's discount rate hike