FYI | Feb 19 2010
By Greg Peel
The US Federal Reserve had flagged its intention to raise its discount rate ahead of any cash rate rise, but still the move came a bit out of the blue after market close. One might have expected the Fed would save the announcement for one of its regular board meetings.
The Fed raised its discount rate by 25 basis points to 0.75%, thus re-establishing a 50 basis point spread over the top end of the Fed's zero to 0.25% cash rate range.
The discount rate is the rate at which US banks can approach the Fed incognito for an emergency loan. Prior to the credit crunch, a spread of 50 basis points over cash was standard for those institutions having to come cap in hand. But when everything started to go awry the Fed quickly slashed the spread to 25bps ahead of its major cash rate reductions. Thereafter, the discount rate was cut by the same level as cash, thus maintaining a 25bps spread.
Wall Street has been anticipating that the Fed will have to raise the cash rate sooner rather than later given an improving US economy. It always made sense that the discount rate would need to be raised first, given it was first to be cut pre-GFC. With the spread re-established, the way is now open for the cash rate to be raised and the discount rate to maintain the 50bps buffer.
While the move should really not come as a shock to anyone, it did take the market by surprise in its timing. Wall Street has not been looking forward to the first rise in interest rates. Perhaps last night's stronger than expected PPI jump was behind the Fed's sudden move, or perhaps the Fed was always going to move this morning anyway.
Either way, the Dow futures are down 60 points as I write in contrast to the 83 point gain made by the average in the regular session. Expect the Australian market to also react.