Fed Surprises Wall Street with Discount Rate Cut

The Federal Reserve used one of its big weapons to contain the sub-prime lending trouble on Friday, namely, surprise. Over the years, central banks have tried to become as transparent as possible in the belief that transparency makes markets calmer. However, when markets are in a panic, a surprise change in the interest rate terrain can have a soothing effect. That’s exactly what happened when the Fed cut the discount rate by 50 basis points; stock indices rallied all day.

The discount rate is the rate the Fed charges to make direct, “emergency” loans to banks (reduced on Friday to 5.75% from 6.25%) and is distinct from the Fed funds rate (stable at 5.25%), which is the rate private depository institutions lend balances (their fed funds) at the Federal Reserve to others overnight. It is a very effective way to pump liquidity into a banking system on a big scale. That fact that the discount rate moved lower while the fed funds rate didn’t is a significant signal to the markets that the Federal Reserve is concerned.

The timing is quite important, too. The Dow and other indices have plummeted in the last several sessions, and markets are traditionally thin on Fridays in August. Thin markets mean more exaggerated moves in prices since there are fewer market participants. So, a surprise on a Friday in August means the reversal of the downtrend with relative ease.

That said, all the Fed has done is save some stockbrokers and banks from losing money. Oil prices continue at historic highs, effectively acting as a tax on the economy. The Federal Reserve’s policy up to now has been to treat rising prices caused by this tax just like it would treat rising prices caused by increased wages – which is the wrong thing to do. Thus, US interest rates are too high throughout the system.

Where the real problem lies is with consumers. There is a genuine risk of a consumer-driven recession before this time next year. The housing market is at its worst in 16 years, unemployment has ticked up, and GDP estimates are being ratcheted down for both 2007 and 2008 because consumers account for two-thirds of that figure. The discount rate cut is a start, but the Fed has had inflation targets set too low and interest rates too high for months, now. This may be the beginning of a policy shift, bringing the Fed into line with what this journal has said for years, “The downside risks have increased appreciably.”

© Copyright 2007 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Fedora Linux.

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