Yes, we noticed
By Daniel M. Ryan
Last Thursday's announcement of the discount-rate hike, from 0.5% to 0.75%, ended up sowing a tempest. Thankfully, the next day's market action made the tempest look teapot-sized – but that's almost certainly the result of deliberate damage control. No less than three members of the Open Market Committee – Atlanta Fed president James Lockhart, St. Louis Fed president James Bullard and Federal Reserve Governor Elizabeth Duke - publicly reassured everyone that the hike was little more than a technical adjustment. The original announcement specified that it was a normalization maneuver, as credit markets are returning to normal. Usually, the discount rate is 1% above the Fed Funds rate. Since the latter rate is still at 0 – 0.25%, the new discount rate will be 0.5-0.75% above it. That's not quite normal, but it's close.
The discount rate only applies to "discounting:" securing a short-term loan from the Fed with a proffered (typically illiquid) loan as collateral. The facility, called the "discount window," is typically used only in times of trouble. The setting of the discount rate above the Fed Funds rate establishes a penalty rate, so the banks can't make a profit by borrowing at the discount window and lending out the proceeds as Fed funds at a profit. [The loan used as collateral is merely hypothecated; the borrowing bank still owns it.] In normal times the amount of discounted loans are near zero. Since the financial crisis erupted, though, the amount of discounted loans shot up to $400 billion.
The current level, as shown by this St. Louis Fed chart, is less than a quarter of that $400 billion. Member banks are using the facility less as the crisis recedes. Given this datum, and other data about the current economy, it's likely that the Fed decided the discount-rate hike would proceed with little market reaction. Although the facility balance stayed stable from April to October of 2009, it has dropped subsequently. Member banks, as a whole, are turning away from the discount window. Jacking up the rate to a nearer-normal level would, seemingly, be no more than a nudge: encouraging member banks to move a little faster in the direction they were going anyway. In and of itself, the only hidden policy statement in the hike is an encouragement to member banks to shake free from dependence on the Fed.
Consequently, the "furor" that greeted the announcement can be cast as irrational. It's already being referred to as the product of a communication difficulty. Putting it this way casts Fed officials as political naïfs, unused to having their actions scrutinized for hidden motives or agendas.
Ben Bernanke himself could be pegged as one. His testimony on February 10th shows the kind of thoroughness one would expect of a former professor. A discount-rate hike was one of several tools that can be used to make monetary policy less accommodative; a Reuters report summarizing them makes the discount option look ancillary. This categorization of it as a merely sundry measure is consistent with the point made in the original announcement: it was not intended a tightening move. From the Fed's perspective, all the ducks were in a row.
Then Why The Row?
In a word, optics. To be more specific, the optics the Fed worthies saw were not the street ones. A wag would say of them, from Bernanke on down, that the discount-rate flap shows their capacity for "optic all illusion."
Perhaps it's best to leave it to the wags. If a sundry maneuver is seized upon as the real deal, instead of as the mildest tool in the shed, the spotlight on the Fed is not entirely a rose-colored beam. People who seize upon an offhand remark as conveying the whole are anxious, suspicious or fearful, or are a combination of the three. This incident does make it clear that Fed Chair Bernanke is now wearing Alan Greenspan's shoes. He's not the post-Greenspan, he's the new Greenspan.
Fragility…Or Moral Hazard?
Needless to say, the Fed Funds rate's extended period is a done deal. If anything, it'll be extended further. It may be Monday-morning quarterbacked a few years from now, but last Thursday's outcry makes plain that the stakes are too high to change course.
To all appearances, the U.S. financial system is still fragile enough to rate extraordinary accommodativeness. Consumer credit growth is still negative. The now-unofficial M3 money supply is actually shrinking, even if M1 is still growing at a decent clip. Not many people would reject the obvious inference. It'd be easier to claim that the last two GDP numbers were flukes.
There is, however, one kind of professional who would demur. Not an economist, not a market strategist, not even a political scientist. The professional I'm thinking of is a social worker.
It doesn't take a long stint as a welfare caseworker to see how dependency flares into outrage. The unaskable question is, to what extent is Wall Street similar to real-life welfare recipients? Did we see a similar kind of desperation, driven by dependency? Is Wall Street, and a large part of the economy, now caught in a welfare trap? Have we seen the bitter fruits of moral hazard begin to ripen?
At this time, the above questions are little more than philosophical. They do, however, point to an issue that should be safe to revisit if the Fed were widely criticized for holding rates down too low, too long.
Daniel M. Ryan is currently watching The Gold Bubble.