THE US Federal Reserve once again took centre stage last Thursday by increasing its emergency lending rate to financial institutions by 25 basis points to 0.75 per cent, the first time since June 2006. The Fed also moved to reduce the tenure of its emergency loans from 28 days to overnight, effective March 18. The discount rate, as it is known, has been close to zero since late 2008 in an attempt to stabilise banks by providing them with access to cheap funds during the financial meltdown. This is not to be confused with the benchmark Fed Funds Rate and does not affect interest paid on credit card, business or home loans in what is a stabilising but fragile consumer credit market.

So what is the impact of the Fed’s decision, and why should investors pay attention to it? The move is considered largely symbolic, and has little material impact on consumers who are still reeling from the effects of the financial crisis. It also has minimal impact on the ability of financial institutions to access overnight and 30-day funds. In fact, bank reliance on this facility has abated significantly as the US economy has moved from deep recession to growth. As at February 17, the day before the Fed announcement, banks had borrowed US$14.1 billion via this mechanism, down 78.5 per cent year on year from US$65.1 billion.

Nevertheless, the decision to increase the discount rate is hugely significant as it is a clear indication by the Fed that economic conditions are improving, and that the enormous levels of support offered to financial institutions, brought on by the credit crisis, is coming to an end. This, as an increase in the discount rate serves to encourage banks to borrow from the broader market, or each other, thus returning the Fed to its intended role as lender of last resort. Most notably, this signals that steps to reverse the dramatic easing in monetary policy could soon be underway.

Despite assertions by the Fed that the Fed Funds Rate will remain “exceptionally low for an extended period”, the sharp reaction in financial markets to the Central Bank’s announcement demonstrates that investors believe that the Fed’s target rate is more likely to increase than remain flat in the medium term. The announcement came after the close of trading on the New York Stock Exchange on Thursday, and immediately sent the Dow Jones Industrial Average (DJIA) lower in the after-hours market. This continued during trading on Friday as the DJIA fell to an intra-day low of 10,316.50, losing 76.4 points or 0.7 per cent before rebounding. The dollar also strengthened against the euro immediately after the announcement, climbing to US$1.3444/euro from US$1.3497/euro, gold fell $11 to $1,112.70, while treasury prices across the major tenures also fell as investors seemed to position themselves in anticipation of higher rates.

So while the market has acknowledged that the increased discount rate may have implications for the Fed Funds Rate, the question remains whether the Funds Rate should indeed remain low for as long as possible, or are we really nearer to the economic security that would warrant a higher rate? Proponents of the low rate will argue that with US unemployment at approximately 10 per cent, and fragile housing and credit markets, an increase in the benchmark rate anytime soon would signal an increase in the cost of funds for the consumer. Even a modest increase in mortgage rates could price out new home buyers and those looking to refinance their mortgages, thus bringing about more foreclosures and a stagnant market. An increase could have a similarly stifling effect on small business, the economy’s main creator of jobs, possibly sustaining or bringing about greater levels of unemployment.

Conversely, many believe that low rates are the main cause of banks’ sluggish return to lending. With banks having access to funds at little or no cost, the incentive to take on relatively high-risk investments, such as business loans, is too small, as banks seem content to continue with conservative investment strategies. Furthermore, with the risk of inflation looming as a result of unprecedented levels of government spending, raising rates sooner rather than later may be necessary to mop up excess liquidity in the market.

What is certain is that the next meeting of the Federal Open Market Committee, scheduled for March 16, will be one of the most anticipated in recent times. Investors will be seeking insight from the Fed regarding expected economic performance, developments in credit markets, the threat of inflation, and, most importantly, how the Fed intends to use its most powerful tool, the Fed Funds Rate.

Sean Robinson is an Equity Trader at Stocks & Securities Ltd. You can contact him at srobinson@sslinvest.com.