When will interest rates rise?

Feb 24 2010 by Andrew Miller, The Journal

OFFICIAL interest rates were cut to very low levels during the financial crisis. With the world economy now starting to get back on its feet, the big question is when the world’s monetary authorities will start raising interest rates back to normal levels again.

China’s policy changes on banks’ reserve requirements earlier this year rattled the markets. They were worried that such policy changes could hinder the incipient economic recovery.

The US Federal Reserve’s decision last week to raise its discount rate from 0.50% to 0.75% also caused some temporary market turbulence. But is the rise in the discount rate really the first step towards pushing up interest rates? Or should we interpret it differently?

A bit of history is necessary here, if we are to put this rate rise in context. The discount rate is the rate at which banks can borrow overnight directly from the US Federal Reserve.

Traditionally, it has been kept 100bps (that is, 1%) above the main official interest measure, the Fed funds rate. This discrepancy was due to the fact that before the financial crisis, banks were only expected to use this borrowing facility in exceptional circumstances – when they were unable to meet their reserve needs through open trading in the funds market.

However, the events of the past two years have necessitated a change of strategy. With banks sometimes finding it very difficult to raise funds on the open market, the Federal Reserve encouraged firms to make more use of this discount facility. But with the Federal Funds rate falling sharply, the 1% discrepancy between the upper end of the Federal Funds target rate and the discount rate became increasingly untenable. So the Federal Reserve progressively reduced it, from 100bps to 50bps and then 25bps. As a result, until last week a Federal Funds rate of 0.25% was accompanied by a discount rate of 0.50%.

Seen from this perspective, the rise in the discount rate can be seen as an attempt to signal a normalisation of monetary policy, rather than an attempt to tighten it. The message is that, with banks no longer finding it difficult to raise money in open trading, they should not need to use the Federal Reserve’s discount window so much. When they do, they should also be prepared to pay a substantial premium for this facility, as happened pre-crisis.

This message of monetary policy normalisation (rather than tightening) was underlined by the accompanying announcement that the Fed would wind up a number of its special credit facilities – for example the Commercial Paper Funding Facility – which had also been intended to ease liquidity conditions in the market in times of stress.

Of course, the Federal Reserve will eventually need to start raising its Federal Funds target rate, but the recent policy change is probably best seen as preparing the ground, rather than the first step along this road. In other words, interest rate rises are not imminent.

Andrew Miller is regional office head at Barclays Wealth in Newcastle