Fed Raises Discount Rate by Quarter-Point to 0.75%

Fed Raises Discount Rate by Quarter-Point to 0.75%

By Craig Torres

Feb. 18 (Bloomberg) -- The Federal Reserve Board raised the discount rate charged to banks for direct loans by a quarter point to 0.75 percent and said the move will encourage financial institutions to rely more on money markets rather than the central bank for short-term liquidity needs.

“These changes are intended as a further normalization of the Federal Reserve’s lending facilities,” the central bank said today in a statement. “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 dollar jumped and Treasuries extended losses as the Fed took another step in a gradual retreat from its unprecedented actions to halt the deepest financial crisis since the Great Depression. The Fed has provided hundreds of billions of dollars in backstop credit to banks, bond dealers, commercial paper borrowers and troubled financial institutions such as American International Group Inc.

“This is an unwinding of another unusual and exigent circumstance,” said David Zervos, visiting adviser to the Fed Board in 2009 who is now a managing director at Jeffries & Co. in New York. “They tried to go out of their way to tell people this doesn’t change their policy outlook at all.”

The dollar rose 0.7 percent to $1.3514 per euro at 5:19 p.m. in New York from $1.3607 yesterday. It touched $1.3502, the strongest level since May. The yield on the 10-year Treasury note rose eight basis points to 3.8 percent.

Rate Increase

The discount rate increase is effective on Feb. 19. The Board also said that effective March 18 “the typical maximum maturity for primary credit loans will be shortened to overnight.”

The Fed Board said the outlook for policy remains “about as it was at the January meeting of the Federal Open Market Committee.” The central bank also cited last month’s statement, which said economic conditions are likely to warrant “exceptionally low” levels of the federal funds rate “for an extended period.”

It was the first increase in the discount rate in more than three years, and the move widens the rate’s spread over the top range for the benchmark federal funds rate to 0.5 percentage point.

“The Fed is moving back to doing business as normal and business as normal is not targeting an exceptionally low fed funds rate of zero to 0.25%,” said Christopher Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. “Today they raised the discount rate, and not tomorrow or the next day, but soon, they will be lifting the fed funds rate target as well.”

Reliance on Credit

Financial institutions’ reliance on Fed credit has waned as market liquidity improved. Discount window loans stood at $14.1 billion on Feb. 17, down from $65.1 billion about a year earlier.

“The increase in the spread and reduction in maximum maturity will encourage depository institutions to rely on private funding markets for short-term credit and to use the Federal Reserve’s primary credit facility only as a backup source of funds,” the Fed Board said in a statement.

“The Federal Reserve will assess over time whether further increases in the spread are appropriate,” the Fed said.

Fed Chairman Ben S. Bernanke telegraphed the move in Feb. 10 testimony to Congress when he said investors should expect a “modest increase” in the rate “before long.” Using language similar to today’s statement, he said a move shouldn’t be interpreted as a change in policy.

Capital Needs

The Fed’s lending programs and their May 2009 review of the capital needs of the 19 largest banks helped restore confidence and liquidity in interbank lending markets. The TED spread, the difference between what the Treasury and banks pay to borrow dollars for three months, has narrowed to 0.15 percentage point from as high as 4.64 percentage points in October 2008.

The central bank closed four emergency lending facilities, including the Primary Dealer Credit Facility and Term Securities Lending Facility, on Feb. 1.

Primary dealer credit stood at $146.5 billion two weeks after the collapse of Lehman Brothers Holdings Inc. in September 2008. The facility had a zero balance when the Fed closed it in February.

The Federal Open Market Committee left the benchmark overnight lending rate in a range of zero to 0.25 percent at their meeting Jan. 27. Minutes from the meeting said officials “agreed it would soon be appropriate” to reduce the term of discount window loans to overnight and widen the spread over the federal funds rate.

Immediate Change

The minutes also said that the discount window change didn’t signal an immediate change in the benchmark lending rate.

Fed officials “generally agreed that such steps to return the Federal Reserve’s liquidity provision to a normal footing would be technical adjustments.”

Prior to the financial crisis, the Fed kept the primary credit discount rate 1 percentage point above the target for the federal funds rate.

The Fed increased the term on the loans to 90 days during market turmoil in March 2008, and reduced it 28 days on Jan. 14 this year.

Discount rate changes are requested by boards of directors at the 12 regional Fed banks. The Fed Board said it approved requests for the rate increase from all 12 regional Fed banks. Discount rate change requests are subject to final review and determination by the Board of Governors in Washington. Fed governors review discount rate requests about every two weeks.