Fed Raises The Discount Rate by 25 Basis Points

Earlier today, the Federal Open Market Committee (FOMC) of the Federal Reserve elected to raise the primary credit rate, also known as the discount rate, by 25 basis points (0.25 percentage point) from 0.5% to 0.75%. This action does not affect the U.S. Prime Rate, so the U.S. Prime Rate remains at 3.25%. The primary credit rate is the rate at which healthy banks can borrow funds directly from the Fed.

Here's are a couple of clips from today's FOMC press release:

"...The changes to the discount window facilities include Board approval of requests by the boards of directors of the 12 Federal Reserve Banks to increase the primary credit rate (generally referred to as the discount rate) from 1/2 percent to 3/4 percent. This action is effective on February 19..."

"...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.

Subsequently, in response to improving conditions in wholesale funding markets, on June 25, 2009, the Federal Reserve initiated a gradual reduction in TAF auction sizes. As announced on November 17, 2009, and implemented on January 14, 2010, the Federal Reserve began the process of normalizing the terms on primary credit by reducing the typical maximum maturity to 28 days.

The increase in the discount rate announced Thursday widens the spread between the primary credit rate and the top of the FOMC's 0 to 1/4 percent target range for the federal funds rate to 1/2 percentage point. 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 Federal Reserve will assess over time whether further increases in the spread are appropriate in view of experience with the 1/2 percentage point spread..."

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As of right now, the investors who trade in fed funds futures at the Chicago Board of Trade have odds at 100% (as implied by current pricing on contracts) that the FOMC will vote to leave the benchmark target range for the Federal Funds Rate at its current level at the March 16^TH, 2010 monetary policy meeting.


Summary of the Latest Prime Rate Forecast:

• Current odds that the Prime Rate will remain at the current 3.25% after the March 16^TH, 2010 FOMC monetary policy meeting is adjourned: 100% (certain)
• NB: U.S. Prime Rate = (The Federal Funds Target Rate + 3)

The odds related to federal-funds futures contracts -- widely accepted as the best predictor of where the FOMC will take the benchmark Fed Funds Target Rate -- are constantly changing, so stay tuned for the latest odds.

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The Federal Reserve Is Changing With The Times

Is it possible that the global financial crisis could produce a painful global depression? Yup, and the Fed knows it. The Federal Reserve is adapting to the current economic environment by making very significant changes to its own rules and regulations:

• Banks can now earn interest on the required and excess cash reserves they have with the Fed. Here's a clip from yesterday's press release:
  
  

  "...The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008.
  
  Employing the accelerated authority, the Board has approved a rule to amend its Regulation D (Reserve Requirements of Depository Institutions) to direct the Federal Reserve Banks to pay interest on required reserve balances (that is, balances held to satisfy depository institutions’ reserve requirements) and on excess balances (balances held in excess of required reserve balances and clearing balances)..."

• The commercial paper market -- where unnumbered American companies go to get short-term loans for things like payroll and inventory -- has all but seized up as a result of the credit crisis. In an effort to unfreeze this market, the Fed is now in the business of buying both unsecured and asset-backed commercial paper directly from eligible issuers. Here's a clip from today's press release:
  
  

  "...The commercial paper market has been under considerable strain in recent weeks as money market mutual funds and other investors, themselves often facing liquidity pressures, have become increasingly reluctant to purchase commercial paper, especially at longer-dated maturities. As a result, the volume of outstanding commercial paper has shrunk, interest rates on longer-term commercial paper have increased significantly, and an increasingly high percentage of outstanding paper must now be refinanced each day. A large share of outstanding commercial paper is issued or sponsored by financial intermediaries, and their difficulties placing commercial paper have made it more difficult for those intermediaries to play their vital role in meeting the credit needs of businesses and households...."

In other Fed news: in a speech today, Ben Bernanke provided a pretty strong hint that a cut for short-term interest rates is on its way. Here's a clip from today's speech:

"...Overall, the combination of the incoming data and recent financial developments suggests that the outlook for economic growth has worsened and that the downside risks to growth have increased. At the same time, the outlook for inflation has improved somewhat, though it remains uncertain. In light of these developments, the Federal Reserve will need to consider whether the current stance of policy remains appropriate..."

Is this a good time for a bear market update? Sure, why not. Since closing with record highs on October 9, 2007, the DJIA has now lost 4,717.42 points (33.304%), while the broader S&P 500 Index has shed 568.92 points (36.349%.), as of today's close.

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As of right now, the investors who trade in fed funds futures at the Chicago Board of Trade have odds at 100% (as implied by current pricing on contracts) that the Federal Open Market Committee (FOMC) will vote to cut the benchmark Federal Funds Target Rate by at least 25 basis points (0.25 percentage point) at or before the October 29^TH, 2008 monetary policy meeting.


Summary of the Latest Prime Rate Forecast:

• Current odds that the Prime Rate will be cut by at least 25 basis points at or before the October 29^TH, 2008 FOMC monetary policy meeting: 100% (certain)
  
• NB: U.S. Prime Rate = (The Federal Funds Target Rate + 3)

The odds related to federal-funds futures contracts -- widely accepted as the best predictor of where the FOMC will take the benchmark Fed Funds Target Rate -- are constantly changing, so stay tuned for the latest odds.

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