Financial Regulatory Forum

BREAKINGVIEWS – Markets right to take Fed move badly

By Reuters Staff
February 19, 2010

– The author is a Reuters Breakingviews columnist. The opinions expressed are his own –

 

By Edward Hadas

LONDON, Feb 19 (Reuters Breakingviews) – The Federal Reserve deserves some sympathy. The U.S. central bank did everything it could to stage-manage its minimal tightening moves, announced late on Feb. 18. But markets reacted as if to serious bad news.

The changes really are small. The main one was to increase the Fed’s discount rate, which is not currently crucial to the financial system, by a token quarter of a percentage point.

That widens the spread between the policy interest rate, currently zero, and the discount rate, which is used for emergency lending to banks, to half a percentage point. Before the crisis, the gap was a full percentage point.

The Fed tried to keep markets calm. It had hinted the move was coming and the press release announcing the changes started by explaining that they were a response to the “continued improvement in financial market conditions”. To hammer the point home, the Fed added that the moves “do not signal any change in the outlook for the economy or for monetary policy”.

If the monetary shifts were as trivial as the Fed claims, then the market response was ridiculous. Stock prices and oil fell by 1 percent or more, while the dollar and U.S. government bond yields rose. Why fly to safety when there is no new danger? If anything, it might seem that investors should welcome small and carefully calibrated moves in the direction of normalcy.

But while investors may have got a little carried away, they are right to consider the beginning of the end of the Fed’s extraordinary measures as bad news for them.

The whole economy has been helped by the ample liquidity support provided by the world’s central banks to counter the financial crisis. But markets have been the greatest beneficiaries. The ample flow of cheap official liquidity has made it possible to bid up the price of all sorts of assets.

The artificial market stimulus is now starting to decline. The pace may be slow, but as the markets’ fuel gets more expensive, they are likely to find the journey bumpier.

 

CONTEXT NEWS

– The U.S. Federal Reserve announced an increase in the discount rate, the interest rate on loans to banks short of cash, from 0.5 to 0.75 percent on Feb. 18. It also shortened the maturity of loans using this facility, which it calls “primary credit loans” from 30 days to overnight. The Fed Funds rate, the standard overnight interest rate, remains unchanged at 0-0.25 percent.

– Link to Fed press release: http://www.federalreserve.gov/newsevents/press/monetary/20100218a.htm

(Editing by Chris Hughes and David Evans)

((Edward.Hadas@thomsonreuters.com))

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