The Fed expects strong economic growth too

02/19/2010 9:01 am EST


Jim Jubak

Founder and Editor,

I guess that counts as a fat reed.

Yesterday at 4:30 p.m. ET—just a minute after I posted my piece on thin reeds that argued that the U.S. economy was growing more strongly than many investors expected —the U.S. Federal Reserve raised its discount rate by 0.25 percentage points to 0.75%.

The discount rate is the interest rate the Fed charges banks to borrow funds. The Federal Reserve also went back to its normal policy of limiting such borrowing to a maximum term of overnight. During the financial crisis the Fed had increased the term of such loans to a maximum of 30 days.

The move indicates that the Fed believes that the U.S. economy is growing strongly enough for it to take this small step back towards business as usual. In that the move adds to the evidence that I cited yesterday for stronger-than-expected economic growth over the next quarter or two.

However, this is a very limited move.

The Fed left its benchmark Fed funds rate at 0% to 0.25% and went out of its way to stress that this didn’t mark any change in its read on the state of the economy or in monetary policy.

I interpret that as the Fed’s way of saying the economy isn’t so strong that it’s about to raise interest rates across the board but things are good enough to unwind one of its emergency policies.

The increase in the discount rate is also important in the light of internal politics at the Federal Reserve. Recently a small but growing minority of voices at the Fed have begun to argue publicly that the Fed should be moving faster to reduce its balance sheet and to remove itself from the financial markets. I think Chairman Ben Bernanke would like to keep dissent from rising further—like his predecessor Alan Greenspan he seems to prize consensus. And this move, small as it is, is an indication that the Fed’s majority has heard the dissent.

Early reaction from the world’s financial markets has been predictable. The U.S. dollar climbed against 14 of 16 major currencies in trading in London (as of noon London time). The S&P 500 futures indicate that stocks will open lower this morning. That wouldn’t be unusual on any Friday that followed three days of gains. Traders typically take profits before a weekend, especially when global financial markets are so full of surprises.

The Fed’s move does suggest that further signs of strength in the economy will lead to other moves that will reduce stock market gains. If the economy strengthens and the Fed raises rates, the interest rate increase is likely to erase some of the potential for stock price appreciation.

The language of yesterday’s announcement says that collectors of thin reeds might still be a few months ahead of the Fed but that the Fed is starting to close the gap on economic expectations.
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