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Everything you wanted to know about the fed...

Contributed by Raymond James

By Scott J. Brown

The Federal Reserve’s Board of Governors raised the discount rate last week. The financial markets were concerned that this was the first step in a tightening of monetary policy. Rather, it was a further step in the normalization of the Fed’s lending facilities. This week, Ben Bernanke will present his semiannual monetary policy testimony to Congress. The Fed chairman is expected to expand on the Fed’s exit strategies and present a cautiously optimistic economic outlook.

The Fed’s toolbox: Banks are required to hold a certain amount of deposits in the form of reserves. Banks can lend excess reserves to other banks or deposit them at the Federal Reserve. The federal funds rate is the rate that banks charge each other for overnight borrowing of reserves. It is a market rate. The Federal Open Market Committee sets a target (currently it’s a range: 0% to 0.25%) and tries to hit that target (through open market operations, the buying and selling of Treasuries on a short-term basis – hence the name “Federal Open Market Committee”). The discount rate, also called the primary credit rate, is the rate that the Fed charges banks for short-term borrowing. Changes in the discount rate are requested by one or more of the Fed’s 12 district banks and approved by the Fed’s Board of Governors. Prior to 1994, the discount rate was the Fed’s chief monetary policy lever. However, in January 1994, the Fed began to announce changes in the federal funds rate target, and it became the main policy tool. In October 2008, the Fed was granted the authority to pay interest on bank reserves held at the Fed (this was supposed to happen in October 2011, but the change was pulled forward in the Economic Stabilization Act of 2008). Note that this could be two rates, a rate paid on required reserves and a rate paid on excess reserves (IOER). In normal conditions, the federal funds rate would trade in a corridor, with the interest paid on excess reserves at the bottom and the discount rate at the top (banks would not lend reserves at less than the IOER nor borrow reserves at rates above the discount rate, for obvious reasons).

Prior to the financial crisis, the discount rate was 100 basis points over the federal funds target. During the crisis, the Fed lowered the discount rate (to 0.50%, 25 basis points above the upper end of the federal funds target range) and lengthened the maturity of discount window lending (first to 30 days, then to 90 days, with no impediment to rolling loans over). Last November, the Fed’s Board of Governors shortened the maximum maturity of discount window loans to 28 days. Effective February 19, it shortened the maximum maturity to overnight and raised the discount rate from 0.50% to 0.75%, but stressed that the moves were not expected to lead to tighter credit for consumers and businesses. The increase in the discount rate was a surprise only in the timing. On February 11, Fed Chairman Bernanke had testified that “before long, we expect to consider a modest increase in the spread between the discount rate and the target federal funds rate.” As part of the “normalization,” the Fed ended most of its special liquidity facilities and canceled its swap lines with other central banks on February 1. Bernanke also cautioned that the move “should not be interpreted as signaling any change in the outlook for monetary policy.”

In his testimony, Bernanke also indicated that “the federal funds rate could for a time become a less reliable indicator than usual of conditions in short-term money markets.” The Fed was considering whether it would “for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates.” Eventually, the Fed would work back to more normal conditions, where the federal funds rate would again be the main tool of monetary policy.

The Fed’s economic outlook has not changed much over the last few months. The recovery is expected to be gradual, with only moderate improvement in the labor market.

The Fed’s central tendency forecasts, which exclude the three highest and lowest forecasts of the five governors and 12 district bank presidents (growth and inflation projections are 4Q-over-4Q, the unemployment rate is the 4Q average for that year):

The Fed continues to view excess capacity as the main factor in keeping inflation low. However, minutes of the January 26-27 FOMC meeting show that officials differed in their views on how much excess capacity was out there. In January, the FOMC continued to signal that conditions are likely to warrant exceptionally low levels of the federal funds rate “for an extended period.” Those conditions include an elevated unemployment rate, a low trend in core inflation, and well-anchored inflation expectations. None of that has changed.

The Fed chairman’s monetary policy testimony has often been a big deal for the financial markets. If there’s a sea change in the monetary policy outlook, it’ll likely happen here. However, we already know the Fed’s outlook and most of its exit plans.