FED FOCUS-"New normal" for discount rate surcharge?

By Pedro Nicolaci da Costa

WASHINGTON, June 8 (BestGrowthStock) – Investors waiting for the
Federal Reserve to raise the premium it charges for emergency
bank loans to pre-crisis levels could be waiting around a long
time — perhaps forever.

To combat the worst financial crisis in decades, the Fed
not only cut official interest rates to near zero but also
sought to overcome the stigma associated with discount window
borrowing by lowering the penalty rate it charges banks.

In the process, it narrowed the gap between the two. Before
the crisis the Fed’s discount rate stood a full percentage
point above the overnight federal funds rate. Now, the
difference is closer to a half point, with the discount rate at
0.75 percent and fed funds in a zero to 0.25 percent range.

Despite the central bank’s effort to draw a sharp line
between liquidity provision and interest rate policy,
economists clearly continue to see the discount rate as an
important guidepost to future Fed moves.

Yet even before Europe’s debt troubles offered greater
reason for caution, policymakers were already contemplating
whether to keep a narrower spread permanently. The jury is
still out, they say, making any near-term increase in the
discount rate unlikely.

“I am open to hearing the arguments” for leaving the gap
between the two rates where it is now, Atlanta Federal Reserve
Bank President Dennis Lockhart told reporters last week.

If anything, Europe’s woes and the associated market
turbulence make any steps that might disrupt the markets even
tougher to justify.

“The Fed is tip-toeing. They’re delighted to see signs of
life in the economy and the labor market starting to create
jobs,” said Ward McCarthy, chief financial economist at
Jefferies & Co. “They’re not going to do anything to derail
that at this juncture.”

The sentiment is not unanimous, however. Three of the more
hawkish regional Fed banks — Kansas City, St. Louis and Dallas
— would prefer to see a “normalization” of the discount rate,
according to minutes from an April Fed board meeting.


Discount window borrowing has fallen sharply from levels
seen during the height of the crisis, but it is still
considerably higher than before the meltdown began during the
summer of 2007.

Borrowing stood at just $678 million in the week ended June
3, down from over $60 billion in March but much higher than the
readings of about $10 million or so that were common before the
onset of the crisis.

Despite the recent decline in its use, investors are keen
to gauge whether and when the Fed will boost the discount rate
again. In February, the decision to raise it by a quarter point
to 0.75 percent sparked a sell-off in financial markets, which
saw it as the opening salvo for a broader policy tightening
despite the Fed’s reassurances to the contrary.

Concern resurfaced on Monday after the Fed announced a
routine meeting to discuss the discount rate. That prompted
Michael Feroli, chief economist at JPMorgan, to issue a
research note to clients entitled “Please remain calm, there’s
nothing to see here.”

Feroli argued the anxiety is probably misplaced. The Fed
would likely telegraph any increase in the discount rate, also
known as the primary credit rate, pretty loudly before actually
taking action.

On Feb. 10, just a week before the Fed’s most recent hike
in the discount rate, Fed Chairman Ben Bernanke was quite
explicit as he testified before Congress: “Before long, we
expect to consider a modest increase in the spread between the
discount rate and the target federal funds rate.”

One factor that might alter the Fed’s thinking is a plan to
offer banks a higher return for parking their reserves with the
central bank for short periods using a reserve-draining “Term
Deposit Facility,” that it will begin testing this month.

Fed officials would like to avoid a scenario where banks
might try to borrow cheaply from the discount window only to
reinvest the money in the Fed’s term deposits at a profit.

Yet with key officials having offered no recent hints about
a discount rate hike, investors can sleep easy for now. Markets
remain volatile and there are plenty of things to worry about.
But a sudden spike in the discount rate is not one of them.

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FED FOCUS-“New normal” for discount rate surcharge?