Federal Reserve & Interest Rates

The Federal Reserve has started to normalize it’s banking policy by raising the discount rate last week, increasing the rate at which it charges banks for overnight lending.  The Fed shrank the spread between the discount rate and federal funds rate early on in the liquidity crisis in 2007 and will probably return to the traditional spread sometime this year as they begin withdrawing their unprecedented stimulus to the banking system.

That being said, banks are still being fairly tight with their lending and while their capital levels have recovered somewhat, they are still in store for more losses with the labor and housing markets in their current states.  Foreclosures are still on the rise and with employment opportunities scarce, that trend will likely continue for some time.

While the economy is expected to grow this year by around 3%, the free flow of credit is lagging noticeably behind in the recovery.  As long as inflation remains muted the Fed would like to keep the federal funds rate near zero for some time.

Banks have recovered to the point where the Fed would prefer them to borrow from each other rather than using their discount window function as lender of last resort.  Another factor that banks are carefully watching is how Congress will revamp banking regulation and how it will impact them in the long run.

So while many people would like to see banks take more risks and lend more freely, impending regulatory changes could serve to discourage risk taking at this time.

The Federal Reserve announced in a press release that it would raise the discount rate by a quarter percent, increasing the cost to which banks can borrow at the discount window.  With the state of the banking system stabilizing, the Fed felt the move was warranted in order to normalize lending from it’s response to the liquidity crisis.

Easing the terms of primary credit was one of the Federal Reserve’s first responses to the financial crisis. On August 17, 2007, the Federal Reserve reduced the spread of the primary credit rate over the FOMC’s target for the federal funds rate to 1/2 percentage point, from 1 percentage point, and lengthened the typical maximum maturity from overnight to 30 days.

On December 12, 2007, the Federal Reserve created the TAF to further improve the access of depository institutions to term funding. On March 16, 2008, the Federal Reserve lowered the spread of the primary credit rate over the target federal funds rate to 1/4 percentage point and extended the maximum maturity of primary credit loans to 90 days.

This may not signal an impending rise to the federal funds rate from it’s near zero level but it is one of a series of moves that will start removing some of the historic stimulus to the banking system.  While the banking system hasn’t returned to normal quite yet, most experts agree it is no longer in crisis.

Until the labor market shows some improvement, the Fed will be reluctant in how much tightening it does to monetary policy.

While the Federal Reserve has laid the ground work in preparing to implement it’s long discussed exit strategy, low interest rates are still warranted for some time.  The economy grew faster than expected in the 4th quarter, at a 5.7% annual pace, but unemployment remains quite high and in order to keep the recovery on pace, the Fed will likely take a deliberate pace when it begins it’s monetary tightening.

Inflation concerns are still minimal at this time and until that changes, the Fed would like to keep credit cheap as long as possible.  Inflation is being forecast at just over 1%, while the economy is expected to grow by at least 3%.

Financial markets and the banking system are slowly recovering but the housing market is still a cause for concern.  The Fed’s unprecedented purchase of $1.25 trillion in mortgage securities is set to end next month and how much mortgage rates will rise after that remains to be seen.

The labor market appears to have hit bottom sooner than expected but unemployment is still unreasonably high.  The economy lost over 7 million jobs since the recession started and it will still take years to get those jobs back.

While analysts don’t expect an interest rate hike until the summer at the earliest, most believe we likely won’t see a rise in rates until the fall.

Federal Reserve Chairman Ben Bernanke was slated to appear before the House Financial Services Committee to discuss the Fed’s exit strategy but due to the second major snowstorm is as many weeks plaguing the Mid Atlantic region, his hearing had to be postponed.  However, the Fed released the transcript of his planned testimony to the public on Wednesday.

Although at present the U.S. economy continues to require the support of highly accommodative monetary policies, at some point the Federal Reserve will need to tighten financial conditions by raising short-term interest rates and reducing the quantity of bank reserves outstanding. We have spent considerable effort in developing the tools we will need to remove policy accommodation, and we are fully confident that at the appropriate time we will be able to do so effectively.

There has been much speculation among investors on when the Fed will begin removing it’s record stimulus to financial system and when it will begin raising interest rates once again.  It was expected that the Fed would hold off on an interest rate move until at least the summer but today’s testimony may signal a move coming before that.

The Fed’s purchase of $1.25 trillion in mortgage securities is set to end on March 31 and that will likely see a rise in mortgage rates soon after.  The housing market is still struggling and we’re still seeing a lot of foreclosure activity, which puts pressure on the banking system.

However, last week’s job’s report saw unemployment unexpectedly fall, the second time that’s happened in three months and if that trend continues it will take a lot of pressure off of the Fed on holding off on it’s exit strategy which has pretty much already started with the phasing out of many of it’s liquidity programs.

The Labor Department released it’s January job’s report on Friday which showed that the unemployment rate fell for the second time in the last three months.  While it’s still too early to declare that the labor market is in recovery mode just yet, it is another encouraging sign for the general economy which continues to gain steam.

The unemployment rate fell from 10.0 to 9.7 percent in January, and nonfarm payroll employment was essentially unchanged (-20,000), the U.S. Bureau of Labor Statistics reported today. Employment fell in construction and in transportation and warehousing, while temporary help services and retail trade added jobs.

A number of forecasts a few months ago had the unemployment rate rising well into the year but it seems that the labor market may have hit bottom sooner than expected.  Still, consumer demand remains well below normal levels so we shouldn’t be expecting any robust job growth anytime soon.

It will still take time for last year’s stimulus package to take full effect in creating jobs for the economy and the Federal Reserve will have to judge carefully when it will start it’s exit strategy as well as raising interest rates once again.  The newly confirmed Bernanke will meet with the House Financial Services Committee next week to discuss the Fed’s monetary policy moving forward.