The US Federal Reserve's decision to raise its discount rate (rate at which the Fed lends to banks) by 25 basis points from 0.50% to 0.75% is surely the clearest signal to the markets that the central banks has started the decent from its extraordinary monetary loosening of the past two years.
It is also the surest indication of the policy makers belief that the worst of the sub-prime crisis and recession is behind and that normalcy is returning back to the credit markets and a sustainable recovery is underway. However, with consumer price inflation for January at just 0.2%, and full recovery some way down the road, interest rates appear set to remain long for the foreseeable future. In fact, the Fed did also announce that it was not yet ready to begin a broad tightening of credit that would affect businesses and consumers as they struggle to recover from the economic crisis and that the short-term federal funds rate will remain "exceptionally low" for an "extended period".
As part of its liquidity tightening, the Fed also announced that the typical maximum maturity for primary credit loans, in which banks borrow from the discount window, would be shortened to overnight, from 28 days, starting March 18; and raised the minimum bid rate for its term auction facility — a temporary program started in December 2007 to ease short-term lending — to 0.50 percent from 0.25 percent.
The Fed’s balance sheet stands at $2.2 trillion in assets, which includes $1.03 trillion in mortgage-backed securities and $165.6 billion in debts guaranteed by housing entities. Short-term Treasury bills, historically a mainstay of the balance sheet, now make up just a tiny fraction of the picture. On the liabilities side, banks hold $1.2 trillion in reserves at the Fed.
The ultra-low rates had presented banks with easy profit opportunities in two ways - access to cheap money and the opportunity to arbitrage on the record spread (2.9% between two and ten year Treasuries) between short and long-term interest rates. The increased discount rates will have the effect of bridging the spread and increasing the cost of capital.
But as a Times article points out, the Fed's exit is a few months behind that in the emerging economies of Asia, indicating the two-track recovery process between the developed and emerging economies. Australia was the first to start the exit, from October 2008, and has already raised its rates three times to 3.75%. Both India and China have raised the reserve ratios (banks have been asked to set aside a larger portion of their reserves) in an effort to limit the amount they can lend to consumers and businesses. Vietnam too raised its rates by a percentage point in November last year.
Update 1 (5/3/2010)
The ECB, which sets monetary policy for the 16 countries using the euro, left its benchmark interest rate at 1%, where it has been since May 2009. The ECB also continues its liquidity support operations to banks. In Britain, the Bank of England left its benchmark rate unchanged for a 12th month, at 0.5%.
Update 2 (21/3/2010)
The RBI in India made a sudden decision, in advance of its April 20 annual credit policy review, to raise its key policy rates – repo and reverse repo – by 25 basis points each with immediate effect to 5% and 3.50% respectively. This is the first rate hike since July 2008.
With headline inflation on a year-on-year basis at 9.9% in February 2010 exceeding its baseline projection of 8.5% for end-March and even manufacturing inflation showing signs of rising, RBI reasoned that "given the lags in monetary policy, it is better to respond in a timely manner, even if it is outside the scheduled policy reviews, than take stronger measures at a later stage when inflationary expectations have accentuated". Signs that recovery is firmly on, with industrial production gaining 16.7% in January following a 17.6% increase in December, also prompted the monetary contraction.
Australia and Malaysia both increased rates this month, as Norway and Israel did at the end of last year.