Fed Tests the Water

Immediately after the stock market closed Thursday, the Fed announced a ¼ percent hike in its emergency discount rate for troubled banks.  It’s a pretty tentative move, but markets are reacting strongly; the dollar is up sharply, stock futures, US Treasuries, and commodity prices are down.  

The reaction is remarkable considering that the Fed has been signaling this move for some time.  Bernanke said in his recent testimony to Congress that raising the discount rate would be an early component of the Fed’s exit strategy.  Just in the past week, at least three Fed regional governors have publicly argued that the looming inflationary effects of monetary and fiscal stimulus need to be addressed soon. 

There’s not all that much discount lending activity going on now that they’ve unwound most of the special facilities, so the reaction must be driven by expectation that this signals continued tightening rather than any immediate curtailment of discount lending. This is despite explicit statements in the Fed announcement that this rate hike is not a tightening on monetary policy, which indicates a decline in the Fed’s credibility among market participants.   

The Fed has dipped its toe in to test the water, and the markets have gotten cold feet.