Fed Watching Has Suddenly Changed

Fed Watching Has Suddenly Changed February 20, 2010, Bob Eisenbeis, Chief Monetary Economist

In a Cumberland commentary yesterday, David Kotok made the correct point that despite the Fed's attempt to indicate that its 25-basis-point hike in the discount rate wasn't a policy move, the action wasn't perceived that way, and it had the effect of introducing more uncertainty into markets.  Some aspects of the move were clearly a surprise.  For example, the move was an intermeeting move and it was announced after markets had closed.  But in hindsight, it is now clear that the move had been planned and even executed long in advance.

The most obvious aspects of the move were that it was telegraphed by the Chairman in his testimony of Feb. 10 (which was never delivered in person) before the House Financial Services Committee and covered in some detail in a section of the FOMC minutes that were released one day before the discount-rate move.  That section was a discussion of the staff briefing on longer-term policy issues and strategies that has become a standard feature of the two-day meetings.  Those discussions usually precede the staff presentation of current economic developments and FOMC discussion of the policy options.  It is not a section of the minutes from which one would expect an immediate policy move to emanate.  The reason for releasing the text of the Chairman's testimony, even though it wasn't given, is now clearer; and it means that much more attention will be paid to testimony, speeches and the minutes - all sections of the minutes - from now on than was the case in the past.  The premium on Fed watching has just gone up significantly.

 But there are other aspects of the move that are interesting, and that now clearly indicate that the discount-rate move had been planned in advance.  It actually may have been executed several days earlier.  It clearly was not the usual intermeeting move. 

These conclusions are especially obvious to those who are familiar with the nuances of the legal structure of Fed policy making.  For example, while the FOMC is empowered to set the federal funds target rate, the Board of Governors is the legal body that sets the discount rate and interest rate on required reserves, not the FOMC.  Since the current policy focus has shifted from the federal funds target rate to the rate paid on required reserves and the discount rate, the Board of Governors is technically in the driver's seat when it comes to setting monetary policy and not the FOMC.

 Another nuance of this structure is that a Reserve Bank president's vote on the FOMC is his or her own decision and is not the purview of the Reserve Bank's board of directors.  This distinction is sometimes fuzzy, and some presidents have conveyed different views as to what the bank's board of directors are actually recommending; but the point is that the Reserve Bank president is expressing and voting according to his or her own views and is not carrying out a decision previously made by the bank's board.

Another institutional detail of the discount rate is critical.  The Board of Governors cannot change the discount rate without having  a recommendation to do so from the board of directors of at least one of the Reserve Banks.  In the recent past, when the discount rate was changed, it was done so in a separate meeting of the Board of Governors in the Chairman's office during a recess of the FOMC meeting.  The change was then separately announced and accompanied with a statement at the same time as the FOMC's statement was released, following the conclusion of its meeting.  Whenever a change in the discount rate was made, the announcement always indicated that the Board had acted upon the request(s) of named Federal Reserve Banks(s).  This was even true when the initial 100 basis point differential between the federal funds target rate and the discount rate was reduced twice during the crisis.  That action was then typically followed the next day or so by requests from the remaining banks that had not previously recommended a change in the rate.  Discount-rate recommendations are required of each Federal Reserve Bank's board of directors every two weeks, and the requests are staggered so that there is at least one fresh recommendation submitted every week to the Board of Governors.

The Board's announcement this time specifically indicated that it had approved the requests of all the Federal Reserve Banks.  It is highly unlikely, because of the staggered nature of the discount-rate requests, that all 12 Reserve Bank boards of directors had decided to request a 25-basis-point change in the discount rate in advance of the  January FOMC meeting.  Moreover, it is unlikely that they all independently decided to recommend the increase after the meeting, given the FOMC's decision to hold rates at their current level for a "considerable period of time," unless they had been specifically asked to do so.  Moreover, the Chairman indicated in his February 10th testimony, some eleven days after the January 27th FOMC meeting and eight days before the move was actually announced, that a change in the discount rate was possible.  Thus, it must have been that the decision to adjust the rate had actually been made informally by the Board sometime around the FOMC meeting, and the instruction was given to the Reserve Bank presidents to get a 25-basis-point discount-rate increase from their boards of directors.  Those requests were then officially acted upon, on or about February 17th.

Normally, discount-window changes can be requested, but there is no certainty that they will be granted, except following FOMC meetings when the funds rate target was changed and the discount rate was pegged to the funds rate.  But in this case, the recommendation had to have been requested, voted upon, and then sat upon by the Reserve Bank boards of directors and the Board of Governors for several days.  This raises the question, given that a third of each bank's board of directors consisted of bankers, whether the temptation to trade on that knowledge might have been too great to resist.

Despite the attempt to return to begin moving to a more normal policy environment by picking the rate that would be least likely to elicit a market reaction, signaling the move (albeit obtusely), separating it from the FOMC meeting, and making the move after the markets had closed,  markets still reacted.  One might reasonably argue that any rate move or even a slight shift in policy would cause such a reaction.  On Thursday and Friday, Fed officials went to great lengths to suggest that this was a technical adjustment reflecting improvement in the financial condition of banks, that it should not be interpreted as a change in policy and that rates are likely to remain low for an "extended period of time."  But we have already been told that the return to normalcy in terms of policy setting would likely center for the moment on the discount rate and the rate paid on excess reserve balances, and ultimately, some form of a corridor system with the federal funds target rate lying between the discount rate and rate on reserves.  This new policy environment can't be executed without a wider spread between the two policy rates, so the widening of the spread is a precursor to that new policy structure.  Markets are reacting to this in a predictable fashion.   It is like going to a track meet to watch the 100 meter dash.  Nothing is expected while the runners are in their sweats, but when those come off, the anticipation of the race sets in.    We may not know when the race will start yet, but what is now clear is that, going forward, market participants are likely to live by the old saying, "Fool me once, shame on you.  Fool me twice, shame on me."

 Markets participants will now be especially vigilant, uncertainty will now demand a rate premium, and it is likely that rates will move much more the next time, or even in advance as race time nears.

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