Comparing The Fed Funds Rate With The Primary Credit (Discount) Rate Over The Past Decade

Much has been said about the 25 basis point Discount Rate rate hike announced on Thursday. Some suggest that this was fully expected, priced in, and that to the Fed this is merely a technicality which will not impact the Fed Funds rate in the least. Others, such as Macro-Man, take a decidedly more pragmatic approach, and ask the simple question: if it really means nothing, why do it? "He" also goes on to suggest some possible trade ideas as a result of this action: we suggest checking out his post for further information.

Instead of speculating what the Fed may or may not do (we doubt even the Fed knows - as Krugman points out, the Fed's action could be a function simply of what political party is currently in charge), we have decided to show a simple comparison of the Discount Rate and the Fed Fund rate over the past 10 years (chart below). A few things jump out: before the crisis started in 2007, the spread between the Fed funds target rate (5.25%) and the primary credit, aka discount rate, which was a 6.25%, was 100 bps. The first notable action that the Fed did vis-a-vis the discount rate was to cut it by 50 bps to 5.25% on the morning of August 17, 2007 (in the heyday of the quant implosion when the market was gyrating like a drunken sailor courtesy of busted quant models at GS Alpha and other core quant shops). The spread was subsequently cut to 25 bps on March 16, 2008, when Bear was unceremoniously handed over to JP Morgan for pennies on the dollar. It remained there until Thursday, when it has again moved to 50 bps.

Looking at the chart demonstrates that there has been not one period over the past decade when there was a substantial widening divergence ever since January 9, 2003, when the current discount rate system (primary, secondary) took over the old system in which adjustment credit, extended credit and seasonal credit were the primary forms of crediting available to depository institutions (which in itself is of course an anachronism - only some of the current Discount Window institutions are, in fact, depository institutions, but that is the topic of another rant). We encourage readers to take a look at 12 C.F.R. Part 201 and Part 204, which was the final ruling for conversion to the current discount rate system, it is a rather interesting analysis (not to mention the fact that prior to 2003, the discount rate was inside the Fed Funds rate, thereby allowing banks to arb the Fed once again, only in a different manner). But in summation, any increase in the primary credit rate has always been followed in parallel, or shortly thereafter, by an increase in the fed funds rate. Just how different will this time be?

As Stone McCarty points out "It is also probably not an accident that the announcement of tomorrow's discount rate hike (and next month's shortening of loan maturities) comes just after the release of the January 26-27 FOMC minutes. The discussion in those minutes further serves to underscore the technical, as opposed to policy, nature of today's move." Yet we think that there is more to this, as the Fed will sooner or later be forced to come face to face with a broken monetary system, in which it stands to lose all control should it not tighten in advance of a potential monetary supply explosion which would lead not only to hyperinflation (should the Fed gets its way, and consumers finally start borrowing), but also to full loss of the Fed's control over the American monetary system. Keep a close eye on this chart: we are confident that the Fed Funds will be hiked before there is another unsymmetrical increase in the discount rate. Alas, the economy is far too weak to sustain a tightening posture at this point. As to what kind of aberrations in the market this action could lead to, we will investigate in the coming days and weeks.