February 18, 2010 / 9:38 PM / in 8 years

Fed hikes discount rate but not tightening policy

WASHINGTON (Reuters) - The Federal Reserve said on Thursday it raised the interest rate it charges banks for emergency loans but insisted that its first rate move since December 2008 would not raise borrowing costs for consumers or companies.

The Fed cast its decision to raise the discount rate to 0.75 percent from 0.5 percent as a response to improved financial market conditions that warrant less of a helping hand from the U.S. central bank.

It went to pains to draw the distinction between the discount rate and its target for overnight interbank rates, its main monetary policy tool, which remains unchanged near zero percent as a fragile U.S. economic recovery struggles to gain traction.

“Like the closure of a number of extraordinary credit programs earlier this month, these changes are intended as a further normalization of the Federal Reserve’s lending facilities,” the Fed said 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,” it said.

The decision, requested by all 12 regional Fed banks and approved unanimously by the central bank’s board in Washington, takes effect on Friday.

Despite the Fed’s effort to distinguish its programs to foster market liquidity from its monetary policy, financial markets viewed the announcement as hinting at an eventual policy tightening.

U.S. stock futures and bond prices fell, while the dollar rose following the announcement. Interest rate futures markets moved to price in a 68 percent chance of a hike in the Fed’s main policy rate by late September, up from 54 percent.

Although Fed Chairman Ben Bernanke said last week the central bank could soon raise the discount rate, the timing of the announcement came as a surprise. The Fed usually moves the emergency loan rate in tandem with the federal funds rate that governs overnight borrowing between banks.

“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.

“This may be one small step back toward the normalization of Fed operations, but in the grand scheme of things, 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 percent.”

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.

The Fed has cautioned that recovery will probably be sluggish, and 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, the Fed said the economy and policy outlook remained about the same as in late-January, when its policy committee reiterated that low-rate pledge.

Before the financial crisis erupted in 2007, the discount rate was typically a full percentage point above the federal funds rate that governs overnight lending between banks, and the Fed’s decision moves it just part-ways back.

The Fed cut the discount rate by a half-percentage point to 5.75 percent on August 17, 2007, when concern about the housing slump flared and financial markets became volatile. That halved the spread between the two rates.

On March 16, 2008, the Fed trimmed a quarter point off the discount rate, leaving it just 0.25 point above the federal funds rate.

Both of those cuts, like Thursday’s hike, came outside of the Fed’s regularly scheduled policy-setting meetings, where decisions on the federal funds rate are taken.

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, to 0.5 percent from 0.25 percent.

“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 said.

The Fed said it would assess over time whether it needed to further widen the spread between the discount rate and the federal funds rate “in view of experience with the 0.5 percentage point spread.”

Additional reporting by Vivianne Rodrigues in New York; Editing by Andrea Ricci and Leslie Adler

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