The Fed's discount rate (or primary credit rate) is not a mainstay for bank funding so hiking that rate is not going to have any clear impact on a bank's cost of funds. Banks try to avoid the discount window.
While markets sold off in the wake of the Fed's announced discount rate hike late yesterday, after some reflection US markets have righted themselves. So we cannot even argue that market rates have been pushed up or equity prices pushed down in reaction to the Fed's move of a largely inconsequential rate- a rate used for leverage in implementing monetary policy.
The fact of the matter is that the Fed is paving the way for a rate hike. It has to get markets back to normal conditions before it can do that. But it will not necessarily hike rates quickly once normal interbank market rate relationships are re-established. But it's fair to say it is unlikely that the Fed would hike rates until it had removed the special facilities and rate arrangements it had put in place to deal with the crisis. In that respect we are now closer to a rate hike than we were before.
The release of the CPI on Friday underscores the subtlety of that message. The CPI headline was up but the core CPI fell leaving inflation really very tame for right now. GDP growth has been strong mostly on technicalities. Job growth has yet to check in and without job growth the recovery does not look solid. There is no reason to expect that the Fed is already trying maneuver to a rate hike even though we can argue that in some ways we are closer to having one.
Markets seem to have sorted this out. It is the situation as it was presented to us by Fed Chairman Bernanke in a statement made about one week ago. While markets were confused by his statement then, that has changed.
Still, with the rate hike the world has changed, too. We can see that the Fed wants to be prepared to hike rates if conditions warrant and that is different from saying that it plans to hike rates soon. Still the Fed's move carries a message. That is that the need for the emergency tactics is over. The Fed is betting on a continued recovery.
While it is possible for the Fed to use a wider spread to the discount rate to pressure the Fed funds rate higher that would take repeated efforts and a consistent strategy. There is no evidence that the Fed is trying to use the discount rate in that fashion. It is more obviously true that the Fed is trying to restore a normal Fed fund to discount rate spread as it claims.
There is some complaining about the Fed hiking rates in a post-FOMC meeting, making its move more of a surprise. But it is also true that making the move in that way made it look less like a move at an FOMC meeting that has monetary policy implications. Moreover, it was not a true surprise since Bernanke had just told us he wanted to do just that.
All in all it is hard to be critical of the what the Fed has done or how it has done it.
Still the new weakness in the CPI and the weakness in Europe's service sector revealed by its flash PMI for the service sector in February gives us some reason to wonder about not just the US but the global expansion. In some ways the timing of the Fed move is peculiar since growth is not exactly building in a clear way. We can understand the Fed wanting to get the interbank market and official rate structure back to normal as soon as possible. But the economy has been so weak for so long that if there is backsliding the possibility that economic weakness turns to financial catastrophe again is quite high.
So it is in that respect that markets were cheered by the Fed's move to normalize the discount rate. That move told the market that the Fed, at least, thinks the banking sector is more sold and that it can stand up by itself without special facilities or rate configurations. The Fed also is betting on growth. We can all hope that the Fed is right on this one.