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Fed hikes discount rate to 0.75 per cent

The Fed cast its decision to raise discount rate as a response to improved market conditions.

Written by Reuters | Washington | Published: February 19, 2010 8:52 am

The US Federal Reserve on Thursday made its first interest rate move since December 2008,hiking an emergency lending rate it charges banks,but insisted borrowing costs would not rise for consumers or companies.

The Fed cast its decision to raise the discount rate to 0.75 per cent from 0.5 per cent as a response to improved financial market conditions that warrant less of a helping hand from the US central bank.

It went to pains to draw a distinction between the discount rate and the federal funds interbank lending rate,its main monetary policy tool,which remains unchanged near zero per cent to help sustain a fragile US economic recovery.

“Like the closure of a number of extraordinary credit programs earlier this month,these changes are intended as a further normalization of the Federal Reserve’s lending facilities,” the Fed said in a statement.

“The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy,” it said.

The decision,requested by all 12 regional Fed banks and approved unanimously by the central bank’s board in Washington,takes effect on Friday.

Despite the Fed’s effort to distinguish its programs to foster market liquidity from monetary policy,financial markets viewed the announcement as presaging an eventual policy shift.

US stock futures dropped sharply and government bond prices fell after the announcement,with the yield on policy-sensitive two-year notes touching their highest level since late January. The US dollar also rose,hitting a nine-month high against he euro and a one-month high against the yen.

Interest rate futures markets moved to price in about a 70 per cent chance of a hike in the Fed’s main policy rate,the federal funds rate,by late September,up from 54 per cent.

Although Fed Chairman Ben Bernanke said last week the central bank could soon raise the discount rate it charges on short-term loans to banks,the timing came as a surprise. The Fed usually moves the emergency loan rate in tandem with the overnight federal funds rate.

“The Fed can talk all day about how the discount rate hike is technical and not a policy move,but the market sees it as a shot across the bow,” said Chris Rupkey,chief financial economist at Bank of Tokyo-Mitsubishi UFJ in New York.

ECONOMIC OUTLOOK UNCHANGED

The central bank’s view of the economy has brightened in recent months as job losses eased,consumer spending strengthened and businesses stepped up purchases of equipment and software.

Still,the Fed has cautioned that recovery from the deepest US recession since the 1930s will probably be sluggish and has said it expects to keep the federal funds rate near zero,where it has been since December 2008,for “an extended period.”

In its statement on Thursday,it said the economic and policy outlook remained about the same as in late-January,when its policy committee reiterated that low-rate pledge.

Some other central banks around the world have begun to tighten policy. Australia led the way last year and China moved earlier this month to restrict bank lending.

In the United States,however,the Fed has said extraordinarily low interest rates are still warranted with the unemployment rate near 10.0 per cent and much of the nation’s industrial capacity still lying untapped.

US President Barack Obama,facing the prospect that his Democratic party will lose congressional seats in November elections,has said job creation is his top priority.

“I don’t think the Fed dares (to) increase the fed funds or policy rate in the face of unemployment at double-digit type of levels,” Bill Gross,the manager of Pimco,the world’s biggest bond fund,said.

RETURNING TO NORMAL

Before the financial crisis erupted in 2007,the discount rate was typically a full percentage point above the federal funds rate. The Fed’s decision on Thursday begins to move it back nearer its traditional premium.

The Fed halved the spread between the two rates in August 2007,when it cut the discount rate by a half-percentage point in a first attempt at taming the credit crisis. It narrowed the spread to just a quarter point in March 2008.

Both of those cuts,like Thursday’s hike,came outside of the Fed’s regularly scheduled policy-setting meetings,where decisions on the federal funds rate are taken. The increase in the discount rate was the first hike in either rate since June 2006.

Other changes announced on Thursday included shortening the typical maximum maturity for primary credit loans to overnight from 28 days,effective March 18,and raising the minimum bid rate for the Fed’s Term Auction Facility,another program put in place to foster market liquidity.

“The increase in the spread and reduction in maximum maturity will encourage depository institutions to rely on private funding markets for short-term credit and to use the Federal Reserve’s primary credit facility only as a backup source of funds,” the central bank said.

It said it would assess over time whether it needed to further widen the spread between the discount rate and the federal funds rate.

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