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Getting Back to Normal
By: Dr. Charles Lieberman
Date: 2/22/2010
The Fed's decision to hike its discount rate, which is largely symbolic, sent a message to investors that economic and financial market conditions are returning to normal, so interest rates must follow suit. Real rate hikes may not begin for a few quarters, but even when they do, policy will remain highly accommodative for a lengthy period of time. Thus, economic growth should continue to build and the outlook remains very positive for stocks. However, bond yields are unlikely to remain so low as long and should rise gradually over time.
The initial reaction to the Fed's action displayed a kneejerk reaction without much thought. The Fed had already suggested that a normalization of policy rates will be coming soon. What better way to start than with an interest rate that is essentially meaningless? Banks traditionally borrow very little from the discount window and have even less reason to do so when excess reserves glut the system, so the discount rate is irrelevant to bank funding costs.
The role of the funds rate will need to be re-evaluated since the Fed now pays interest on excess reserves, which greatly reduces the need of banks to borrow or lend in the funds market. Indeed, trading volume in fed funds has declined very sharply. So the key to policy will be the interest rate on excess reserves. Still, that will lead to a high degree of uncertainty, since a high level of excess reserves implies that banks could sharply increase lending activity at any time. The Fed and the market will need to figure all this out to understand the Fed's policy stance.
So what can we infer from the Fed's action? It is absolutely clear that the Fed would not be hiking rates of any sort, not even insignificant rates, if Fed officials thought the economy remained mired in recession. Only hysterical critics jumped to the conclusion that the Fed is really tightening policy. Rather, the Fed's truly modest step is nothing more than a token indication that economic conditions are beginning to return to normal. So the equity market's rebound after its initial decline was entirely appropriate. In time, as economic momentum builds, policy will have to become less expansion oriented. As job growth picks up, so will consumer spending and corporate profit growth will get turbocharged. All this is very promising for stocks and equally problematic for the bond market. Policy will remain friendly until this becomes indisputable.
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