The End of Easy Money Is Near

“The Financial World According to Inya” Column,
by Inya Ivkovic, MA

It has begun — the raising of interest rates, that is. Last week, the Federal Reserve started tightening the tap on easy money by increasing the interest rate it charges on short-term loans to banks — the “discount rate.” This is the first signal that the Fed is trying to rein in the excess money supply and implement an effective exit strategy. As banks have opened their lending purses more, and more prudently, the Fed thought it was time to boost the discount rate by 25 basis points, from 0.50% to 0.75%.

The Fed was quick to clarify that increasing the discount rate is not likely to tighten financial conditions for consumers and businesses, that the economic outlook is not going to change significantly, and that the U.S. monetary policy is not swinging in the opposite direction. Regardless, assurances that “all is quiet on the Western front” (to borrow from Erich Maria Remarque) and the timing of the announcement have had their consequences, including a bit of a commotion in after-hours trading and quite a bit of a boost to the U.S. dollar.

Why such a fuss if the move was indeed symbolic? I suppose what happened could be equated to driving on the first snow of the season. Don’t you ever feel that people simply fall victim to collective amnesia when the first snow comes and completely forget how to drive? It seems something similar happened after the Fed raised the discount rate for the first time in a while and the market responded the only way it knew how — going slightly into disarray.

Boosting the discount rate also comes just as the U.S. economy has entered the fragile recovery cycle. If only the economy were still not shedding jobs and the banking industry were still not as weak, both of which ended up at the top of the list of reasons why the Fed wanted to keep its interest rates low and the recovery on track. That said, the banks’ key rate; that is, the overnight federal funds rate, still hovers at near-zero levels of 0.25%. The expectation is that this rate will remain unchanged at least until later in the year, potentially even until early 2011. The pace, of course, is completely dependent on the economic recovery, or lack thereof, whichever ends up being the case.

When the credit and financial crisis were at their boiling points in 2008, the Fed nearly eliminated the gap between the discount rate and federal funds rate, hoping this would encourage banks to come to the Fed if they needed emergency infusion of short-term cash. However, as the credit crisis appears to be waning, prime brokers appear less and less dependent on the “discount window.” To illustrate, when things were the worst in late 2008, short-term borrowing hit $100 billion. Currently, such borrowing has plunged to $15.0 billion, representing a negligible fraction of the Fed’s $2.2-trillion balance sheet.

Analysts believe the Fed’s move is purely of a technical nature, simply an adjustment needed to return the spread between the discount rate and federal funds rate to a more normal. This is further supported by the Fed’s statement that it is not changing course on the monetary policy. Still, it seems investors are not convinced.

I’m all for not reading too much into things, particularly into things that aren’t there. However, there are macroeconomic factors that are making me exceedingly uneasy and worried about how all the dots will connect in the end. China, for example, is tightening its monetary policy and selling U.S. government debt securities. The fear that the U.S. might not be able to sustain its debt-laden balance sheet for very much longer appears almost palpable among the world’s largest holders of U.S. government bonds and Treasuries. Additionally, despite getting a boost when the Fed raised the discount rate, the outlook for the U.S. dollar remains dismal. Worst yet, the economic recovery in the U.S. rings hollow because the labor market is deeply in trouble.