Last week, the Federal Reserve raised the interest rate it charges banks borrowing from its discount window from 0.50% to 0.75%. Investors initially expressed surprise and alarm that a new cycle of monetary policy tightening and higher interest rates had begun.
Federal Reserve officials immediately worked to assure financial markets that this was not the case. The discount rate had been lowered dramatically to help banks stressed for funding in the middle of the financial crisis. As lending markets have thawed, banks have found alternative sources of funds and no longer were lining up at the Fed’s emergency window. The special subsidy of an exceptionally low discount rate was no longer required.
The discount rate hike is part of other actions the Federal Reserve is taking to unwind some of the extraordinary measures it had implemented to rescue financial markets from collapse. The next most important step will be the halting of its program to purchase mortgage bonds issued and backed by the housing agencies, Fannie Mae and Freddie Mac, at the end of March.
Federal Reserve officials continue to debate when they will deploy the tools to be used as their primary monetary policy levers. These will include paying higher interest rates on the excess reserves banks hold, actively draining reserves from the banking system, and raising the target on the federal funds rate. While some monetary policymakers are arguing for a quicker response, the general view from the Fed is that explicit tightening is still a number of months off.
The fact that the Fed is pulling back on various emergency programs does indicate greater confidence in the economy’s recovery prospects. By the second half of this year, Fed actions are likely to indeed mean higher interest rates.