Comment

Stock markets across Asia and Europe fell sharply on Friday on concerns that a largely symbolic tightening action by the US Federal Reserve Board overnight signals the beginning of the end of the easy money that underlies much of the global economic recovery — and the avalanche of liquidity that’s driven up asset prices.

The Fed announced late on Thursday it was raising the discount rate — at whichbanks borrow from the Fed’s emergency liquidity facility — by 25 basis points to 0.75%.

In a statement, it emphasised that this did not suggest a change in its outlook for the US economy or for monetary policy, which has been superloose.

Instead, it said, it was aimed at encouraging financial institutions to rely more on the money market — rather than itself — for shorter term funding requirements. In short, it was intended as a further “normalisation” of the Fed’s lending facilities — and a sign that financial markets, which were on the brink of collapse late in 2008, had substantially healed.

Why then did the markets react negatively to this news? What does the Fed action imply — for economic recovery, for the financial markets, and for currencies and commodities? DNA distills the information, with perspective from economists.

1. What is the discount rate, and how significant is the Fed hike?
According to Societe Generale analyst Aneta Markowska, the ‘discount rate’ is the rate at which banks borrow from the Fed’s ‘discount window’, which is an emergency funds facility. The facility has traditionally been used by banks in times of emergency to borrow at a penal spread above Fed funds.

Historically, the spread was 100 basis points, but in response to the financial crisis of 2008 - when the need for emergency liquidity was high — it was lowered to 25 bps. But the Fed has been gradually winding down liquidity support programmes since they’re no longer needed, a sign that financial markets are healing. Indicatively, use of the discount window declined from $112 billion in October 2008 to $14 billion last week.

Ryan Sweet, senior economist at Moody’s Economy.com, says that a higher discount rate “makes sense, particularly since the Fed has closed many of its emergency lending facilities and demand for funding has slowed substantially.

2. Does this signal a tightening of monetary policy?
The discount rate hike, says Markowska, is a technical move that will not have any tangible impact on the economy.

The discount rate is the “least important” of the Fed’s targets — and clearly not as important as the fed funds rate or interest paid on reserves. But although the Fed move is largely symbolic, it “sends a very powerful message” - that the Fed is moving faster than anticipated, “and the pace suggests that we should anticipate outright rate hikes in the second half of 2010 rather than early 2011 as we previously expected.”

The “hawkish dial” at the Fed has been moving up in recent weeks, adds Markowska. “But the decision to increase the discount rate marks the biggest shift yet in the Fed’s message.”
According to HSBC economist Stuart Green, the discount rate hike will have only a “small” monetary tightening impact in interbank markets. In fact, he reasons, the reduced implications from this action may have encouraged the Fed to take such a measure in the first place, so as to “gauge the market reaction to an early move in what we expect to be a drawn-out process of policy tightening.” The discount rate hike, he adds, is “a step towards an eventual tightening rather than a shift in policy itself.” He still expects the Fed to leave rates low for longer - given the sub-par economic recovery and the absence of inflationary pressures.

3. Why did the financial markets take it so badly?
The Fed move is not without significance for markets within and outside the US, reasons Green. Following on similar sentiments from central banks in Europe, the Fed move “is a further indication of the intention of central banks to move away from the emergency liquidity provision of the past two years… Effectively, the Fed is signaling a determination to wean financial markets off the unsually generous supply of central bank liquidity should the economic data permit this.”

Adds Sweet: “The Fed is attempting to wean banks off government sources of liquidity. It wants depository institutions to rely more on private funding markets and banks to shore up their capital the old-fashioned way—by borrowing short and lending long.”

4. What will this do to the US dollar - and to emerging market currencies?
The US dollar was boosted by the discount rate hike towards the end of the US session on Thursday, notes Samarjit Shankar, managing director of global strategy at Bank of New York Mellon. That boost came about because investors believed this may signal the Fed is closer to eventually raising the Fed funds rate, the most important policy tool for the Fed. But, he reckons, “the greenback’s knee-jerk gains are likely to dissipate as market participants digest the full import of the decision.”

HSBC currency strategist Robert Lynch reckons that perceptions that central banks were reducing liquidity “could prove problematic for the risk trade in the near term.” And that, he reckons could benefit the US dollar. It is however, not clear if the dollar will have more sustained support, particularly after the Fed’s “announcement effect” subsides.

For the same reason, insofar as the Fed move is helpful for the US dollar in the short term, it will likely serve as a negative influence for emerging market currencies, which benefited from the dollar carry trade, point out currency strategists Clyde Wardle and Daniel Hui. “However, we question for how long such a move will last”, given the Fed’s statement that this is not a measure aimed at tightening credit conditions.

5. Will gold lose its glitter?
Highly accommodative monetary policies have been an important element in the gold rally, points out precious metals analyst James Steel. To that extent, the Fed move will in the short term be “gold-bearish” since it reduces liquidity. But if, as the Fed suggests, the discount rate hike does not signal a change in monetary policy and if this implies that monetary policy will remain lax, the gold sell-off may be brief, he believes. Pointing out that the gold market absorbed the news of an IMF sale rather well, Steel notes that the last time gold prices dropped below $1,100 an ounce, it was accompanied by an increase in physical buying in emerging markets.