Is The Fed About To Announce An Increase In The Discount Rate?
One of the things that spooked the market yesterday was not so much any concerns of tightening language in today's FOMC statement, as much as a rumor that the Fed was planning on bumping up the discount rate. Krishna Guha, in a blog post, wondered, "might the Fed raise the discount rate at this week’s policy meeting? I
think this is a possibility and should be considered as a risk factor.
But I would not include a discount rate increase in my base case
forecast for the meeting." The key reason for this would be the increasing desire of the Fed to "draw an increasingly sharp distinction between liquidity policy and
monetary (interest rate) policy in the spirit of the ECB’s separation
principle at this meeting and in subsequent communications." Yet the question remaind: is the Fed about to hike the Discount Rate?
Goldman provided some additional thoughts:
The logic for increasing the discount rate rests on “normalization” (Guha’s word) of the unconventional component of the Fed’s policy mix and not on normalization of short-term interest rates, which in Guha’s view is “still some way off.” Thus, if the Board chose to do this the emphasis would be on increasing the spread between the discount rate, which currently stands at 50 basis points (bp), and the federal funds rate, currently targeted between zero and 25bp, as just another step in a sequence of moves that have already been taken to wind down the facilities by making them less attractive to banks. Since late June, the Fed has periodically reduced both the amounts on offer in its auction facilities – the Term Auction Facility (TAF) and the Term Securities Lending Facility (TSLF) – and the terms on these and other facilities, including discount window loans (to be available for up to 28 days instead of the current 90 days as of January 14, 2010). As a result of these changes as well as the general improvement in financial conditions, the combined outstanding balances in liquidity and commercial paper facilities has dwindled from $1.2 trillion (trn) as of late June, when the first of these changes occurred, to $135bn last Wednesday. Given this progress and the normalization in the financial markets at large, why would it not make sense to start raising the discount rate?
Our answer – and we believe the FOMC’s answer as well – is that a discount rate increase would risk a lot more than it would achieve. Even if advertised loudly as something other than a hike in short-term interest rates, the financial markets would inevitably treat it as the precursor of such a move. Note in this regard the selloff that developed in fixed-income markets as this story circulated yesterday. Meanwhile, the benefit in terms of shrinking either the Fed’s balance sheet or the volume of excess reserves would be trivial. As of Wednesday, the outstanding balance at the discount window was just $19bn – less than 1% of total Federal Reserve assets ($2.2trn) and less than 2% of excess reserves ($1.1trn). By comparison, outstanding TAF balances were nearly $86bn. Moreover, some of these loans (at either facility) may be to banks that need short-term liquidity but still perceive a stigma to revealing this need to other banks at a time when most of them are swimming in excess reserves. Thus, while Fed officials may wish at some point to restore a wider spread between the discount rate and federal funds target rate -- we’re not even sure of that given the difficulty they encountered in getting banks to use the discount window early in the crisis, when the spread was 100bp – they are apt to leave the spread alone until rate hikes of a more conventional variety are closer at hand if not already underway.
While the Fed has now heard loud and clear what the real policymaker, Goldman Sachs, feels about any less than accommodative monetary policies, the money printing institution does have to be concerned about the ever increasing desires out of all legislative bodies to curb its drunken sailor ways. And a discount rate increase may just be that middle ground that placates many of the popular concerns vis-a-vis eventual tightening, as well as reminding that Bernanke's policies are not solely geared to perpetuating the taxpayer subsidized zero cost of capital bank piggy bank.
So with most eyes glued to every word of the Fed Statement, here is, once again, what Fed HoldCo Goldman Sachs believes will come out of the Fed at ~ 2 pm today, in a sentence by sentence read of the expected release:
While there have been upside and downside surprises over that period, on balance these surprises have prompted upgrades to growth estimates for the fourth quarter. Consequently, we see a number of spots in the first paragraph, which is devoted to a summary of recent growth developments, where the FOMC could upgrade its assessment. Taking the November 4 version of that paragraph sentence by sentence:
“Information received since the Federal Open Market Committee met in September suggests that economic activity has continued to pick up…This remains true, with GDP tracking into the fourth quarter at a stronger pace than now posted for the third. However, the acceleration is due mainly to faster progress in reducing the pace of inventory liquidation; for example, we estimate that real final sales are currently rising at a 2.3% annual rate, about the same as the 1.9% rate posted for the third quarter.
…Conditions in financial markets were roughly unchanged, on balance, over the intermeeting period…Fed officials could justify a more upbeat tone here. Our Goldman Sachs Financial Conditions Index (GSFCISM) has eased by about 30bp since early November, mostly due to an increase in stock prices. Dollar weakness has also contributed modestly, though some would not see this as an improvement; in any case, Fed officials would not be specific about the sources of better financial conditions.
…Activity in the housing sector has increased over recent months…This is true with respect to sales of existing homes, so the sentence will probably stay. However, starts have suffered a setback in the past couple of months, which might prompt a qualification of some sort.
…Household spending appears to be expanding but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit…This is still broadly true. However, the latest labor market report was much better than expected, in contrast to the one released just after the last FOMC meeting. So we could see a modest upgrade here if Fed officials choose to give more weight to recent data.
…Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales…The staffing part of this might disappear in recognition of the reduced pace of layoffs, but the rest still appears to be true, especially insofar as inventories are concerned.
…Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.” With private-sector (and undoubtedly Fed staff) economists marking up forecasts for the fourth quarter, the introductory phrase will probably be tweaked. The committee may also point out that they are starting to make progress in increasing capacity utilization. However, we doubt that the overall thrust of the sentence will change.
The one-line second paragraph on inflation – “With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.” – is broadly still true despite an uptick in core retail inflation. Tomorrow’s report on the CPI will provide a fresh reading on this. (We expect a 0.17% increase in the CPI core; the consensus looks for a 0.1% increase.) While retail gasoline prices have edged up at a time of the year when they normally fall, crude oil prices have fallen since early November and indexes of commodity prices have been mixed. Meanwhile, the jobless rate has risen on balance from the 9.8% for September that the FOMC was looking at in early November, capacity utilization is in the low 70s, and large overhangs prevail in real estate markets. Long-term price expectations as measured in the Reuters/Michigan consumer sentiment survey fell substantially in early December, while the implied 5-year inflation rate five years forward is about where it closed on November 4.
In the final, policy-oriented paragraph, the sentence announcing the reduction of the targeted amount of agency purchases to $175bn from $200bn will clearly go, but otherwise we do not anticipate any changes. In particular, for the reasons just cited for the inflation outlook, the key policy sentence for interest rates
“…The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period…
is unlikely to change, nor is the outline of credit easing that follows:
…To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. In order to promote a smooth transition in markets, the Committee will gradually slow the pace of its purchases of both agency debt and agency mortgage-backed securities and anticipates that these transactions will be executed by the end of the first quarter of 2010.”
Other parts of this paragraph are relatively uncontroversial – promising “to employ a wide range of tools to promote economic recovery and to preserve price stability .… [to] continue to evaluate the timing and overall amounts of [the FOMC’s] purchases of securities in light of the evolving economic outlook and conditions in financial markets …. [and to monitor] the size and composition of its balance sheet and [to] make adjustments to its credit and liquidity programs as warranted.” – and therefore likely to stay as written.
So while overall there is little room for surprise out of the FOMC, the possible Discount Rate increase could cause quite a stir if Guha is indeed right. And indeed, the credit markets are certainly much more skeptical of the continuing status quo than equities, which are blindly continuing in the only direction that the volumeless and computer-driven "rally" will allow them to go.