The Fed Increases the Discount Rate and Markets Yawn

The Federal Reserve last week announced that it had raised the discount rate – the interest rate at which member banks, which now includes GMAC and other formerly non-bank financial institutions, can borrow from the Fed – by 25 basis points, from one-half of one percent to three-quarters of one.

It is no wonder that capital markets reacted as if nothing of substance, monetary policy-wise, had happened. Widely interpreted in the press as a “signal” that the Fed will sometime in the unknown, but perhaps foreseeable future begin reversing the easy money policy it adopted in response to the financial crisis that began in December 2007, the discount rate move was nothing of the sort.

It is ludicrous to characterize the discount rate as the interest rate that penalizes banks for having to apply for “emergency” loans from the central bank.

If it is to serve that purpose, as I learned at the knees of Tom Saving and Phil Gramm, the discount rate must closely approximate the market interest rate. Banks otherwise will have incentive to borrow funds from the Fed and then relend them at a profit. Given that market interest rates on mortgages and other secured consumer loans currently are running at five or six percent per year, it makes only a small difference in profitability if lenders can borrow from the Fed at three-quarters rather than one-half of one percent.

(An old banker’s rule from earlier times: 5-9-1. Borrow at five percent, relend at nine and be on the golf course by one.)

Borrowing at the discount window remains quite profitable. So, why are banks apparently reluctant to make loans? The answer is not a lack of liquidity or loanable funds. The answer is credit risk. Many lenders have learned to their chagrin to be wary of extending credit to borrowers who are unlikely to repay, unless, of course, those loans can be resold to Fannie Mae or Freddie Mac, thereby shifting the risk of default onto the taxpayers’ tab.

Monetary policy has become dysfunctional and counterproductive under Ben Bernanke’s watch. If his regime had intended to signal a reversal of easy money and a return to the Fed’s primary objective of maintaining a sound currency and a stable price level, the discount rate would have been raised much more dramatically.