Federal Reserve Surprises By Raising the Discount Rate

(A version of this post also appears on ONE-TWENTY TWO)

The Federal Reserve essentially warned us in its most recent written testimony to the House of Representatives that part of its exit strategy from emergency monetary measures is to increase the spread between the funds rate and the discount rate. This evening, the Fed did just that. In a surprise announcement, the Fed increased the discount rate from 1/2 percent to 3/4 percent and accordingly widened the spread with the funds rate.

Once again, the Federal Reserve reassured us this action does not change monetary policy:

“The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy, which remains about as it was at the January meeting of the Federal Open Market Committee (FOMC).”

This caveat probably means we should still not expect an increase in the funds rate until November/December at the earliest. However, I think the Fed’s surprise delivery of this message puts us all on notice and forces an attitude adjustment. The Fed is serious about normalizing monetary policy and moving away from emergency measures.

The Fed’s timing is particularly odd given options expire tomorrow. Typically, such timing is executed to squeeze shorts and force a market rally. There could be a lot of churn as market participants rush to adjust in the middle of dealing with expiring options. Already, the dollar has rallied sharply in the past several hours.

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