What the Hike in the Discount Rate and Window Dressing Have in Common

“Profit Confidential” Column, by Michael Lombardi, CFP, MBA

We’ve all heard the news by now: last night, the Federal Reserve Board announced it would be raising its Discount Rate by a quarter-point to 0.75%. The “Discount Rate” is the interest rate charged to banks for direct loans. The Federal Funds Rate, which is the key Fed interest rate, remains unchanged.

So, will the increase in the Discount Rate mean a difference for you? The quick answer is no.

The hike in the Discount Rate that becomes effective this morning is the first increase in the Discount Rate since June 2006. This move is basically the Fed’s first signal that the emergency measures it undertook at the depth of the recession are starting to be removed. As Bloomberg.com stated this morning, the Fed is starting to reverse “the most aggressive monetary policy easing in its 96-year history.”

While you will not read this anywhere else today, and true to my contrarian view, I see the Fed’s Discount Rate increase as window dressing…a message that all is going back to normal with the economy, so let’s start putting a dent into the stimulus reversal.

And, while most of what I read this morning in the business newspapers and Internet says that the Federal Funds rate, the key Fed interest rate, will not rise until the fourth quarter of 2010, I’m not so sure. Will interest rates not be forced higher as inflation sets in? (See “Michael’s Personal Notes” below.)

Right now, the Fed is not so worried about inflation, because it’s just coming out of a wrestling match with deflation. Most economists are not worried about rapid inflation setting in either.

Maybe I’m the only fool.

The window dressing is in place. Maybe I’m wrong, but after the Fed surprised the market by raising the Discount Rate last night, a “surprise” hike in the Fed’s benchmark Federal Funds Rate would not surprise this financial commentator.

Michael’s Personal Notes:

There are two groups with different economic views on the inflation front: those who believe deflation (lower prices) lie ahead; and those who believe rapid inflation (higher prices) are ahead for us.

Here’s what I wrote on these pages back in November 2006, “U.S. retail sales are falling, the producer price index is crashing, house prices, car prices are all falling — and no one is talking about deflation but me. Fed governors are still talking about inflation — they’ve got it wrong. Deflation is about the worst economic state a country will experience. The risks to the U.S. economy in 2007 are greater than I’ve seen in years.”

Of course, we all know now that the years 2007 and 2008 saw declining prices for just about everything. Seeing the threat of deflation by the end of 2007, the Federal Reserve moved quickly to drop interest rates and flood the financial system with money. A good move that fended off the “Great Depression, Part II.”

But now, with all the forms of stimulus that have hit the market (and, yes, I know everyone is concerned about deflation), I’m worried about rapid inflation creeping upon us. Yesterday, it was announced that inflation for Canada was up two percent in January 2010 from the same month a year earlier — at the very high end of the Canadian central bank’s target. The Canadian economy is tied very closely to that of the U.S. And with so many U.S. dollars in circulation because of the Fed’s easy money policy, I don’t see the U.S.’ coming inflation far off.

Where the Market Stands:

So much for the naysayers!

To all those analysts and advisors who thought the bear market rally that started in March 2009 was over, you were wrong. After several bullish secessions, this morning, the Dow Jones Industrial Average sits only 35 points away from breakeven for 2010.

Now, I’m reading that analysts say the Dow Jones will not break to a new high for 2010. (That high was 10,767 set in January). I wouldn’t be so quick to make that call. In my opinion, I would not be surprised to see the Dow Jones move to a new high for 2010; in fact, Dow Jones 11,000 is looking good.

Until proven otherwise, I see the bear market rally still alive and well. Remember, dear readers, stock market rallies usually end when the majority of investors believe they won’t…when the speculators bring the market higher and the consensus is that all is well. That never happened with this rally. To get to Dow Jones 10,767, the stock market climbed a “wall of worry” and suspicion that remains today.

What He Said:

“I’ve been writing to my readers for the past two years claiming the decline in the U.S. property market would not be the soft landing most analysts were expecting, rather a hard landing. My view remains unchanged. The U.S. housing bust will be cut deeper and harder than most can realize today.” Michael Lombardi in PROFIT CONFIDENTIAL, June 13, 2007. While the popular media were predicting a bottoming of the real estate market in 2007, Michael was preparing his readers for even worse times ahead.