Fed raises interest rate on emergency loans to banks

By Neil Irwin
Friday, February 19, 2010

The Federal Reserve on Thursday took another step toward winding down its expansive efforts to prop up the financial system, raising the interest rate that banks must pay to take out emergency loans.

Banks that need emergency funds through the Fed's "discount window" will now have to pay 0.75 percent, not the 0.5 percent they have been paying. But that higher rate probably won't mean higher borrowing costs for ordinary households and businesses, and the move does not represent an effort by the Fed to drain the money supply. That would be done by raising the federal funds rate, traditionally the Fed's main tool for managing the economy, above its current level near zero, or by raising the rate it pays on bank reserves, now 0.25 percent.

But Thursday's step was part of an effort to withdraw the Fed's extraordinary support for the financial system, even as it leaves in place ultra-low interest rates to support the economy more broadly. In 2007 and 2008, the central bank took a string of unconventional steps to try to keep money flowing as banks were suffering a cash crunch and unwilling to lend money to one another.

Financial system healing

Now, though the broader economy is still suffering, the financial system has been healing. On Feb. 1, the Fed closed down programs to support short-term business lending and offer emergency loans to investment banks, and it will end purchases to prop up the mortgage market on March 31.

"This move is part of the removal of unconventional measures and should not be seen as a signal of a change in the Fed's monetary policy stance," said Bruce Kasman, chief economist at J.P. Morgan Chase.

The Fed also shortened the terms of discount-window emergency loans to banks and said it would wind down the Term Auction Facility, which pumps money into banks, on March 8.

The Fed went to considerable lengths to stress that its actions do not indicate an effort to slow down the pace of economic growth.

"With these changes, we expect that banks will use private sources for normal funding," turning to the Fed only as a backup source of funding, said Fed Governor Elizabeth Duke in a speech Thursday night. "I'd emphasize that the changes . . . represent further normalization of the Federal Reserve's lending facilities; they do not signal any change in the outlook for monetary policy and are not expected to lead to tighter financial conditions for households and businesses."

Before the financial crisis in 2007, the Fed's discount rate was a full percentage point above the federal funds rate, a gap that indicated the penalty banks had to pay for getting access to emergency funds. As financial markets froze in August 2007, the first major step the Fed took to address the crisis was to narrow the gap between the two rates, a step intended to push money into the financial system. But at that time, the Fed did not cut the federal funds rate because the economy still seemed to be in fine shape.

Now, the situation has reversed. The economy is still weak, and Fed leaders expect unemployment to remain high for some time, so they are keeping the federal funds rate near zero. But the financial crisis has ended, so they want banks and other financial institutions to get back to their normal practices, which includes paying a higher premium for emergency loans.

The Fed will probably widen the gap over time, ultimately getting back to a full percentage point spread. The Fed said in a statement that it "will assess over time whether further increases in the spread are appropriate."

Underscoring the continued weakness in the economy, the pace of job losses rose last week, according to new data released Thursday, and wholesale prices spiked. Although most indicators show that the economy continued to expand at the beginning of 2010, the latest readings show undercurrents of both continued weakness in the job market and a rise in fuel prices that could drain Americans' wallets.

Wholesale prices jump

The producer price index rose a surprising 1.4 percent in January, the Labor Department said, primarily due to higher energy prices. Core inflation, which excludes volatile food and energy prices, rose 0.3 percent, driven by a 1.3 percent rise in pharmaceutical prices.

Economists generally view inflation as little threat in the near future, but that view could change if the latest producer price reading turns into a broader trend of rising prices. Such a situation would put the Fed in a difficult situation. The central bank's leaders have said they intend to leave their target interest rate "extremely low" for an "extended period," but sharply rising prices would limit their ability to follow through on that intention.

Still, analysts expect the January rises to reverse in February, based on prices in commodity markets for energy and metals.

"Producer prices jumped in January in response to unusual seasonal pressures on crude oil and natural gas prices, pressure that will dissipate in February," said Brian Bethune, chief financial economist at IHS Global Insight.

Also Thursday, the Labor Department said that 473,000 people filed new claims for unemployment insurance benefits last week, up from 442,000 the previous week. That is a worrisome sign that the job market might not be improving at the pace forecasters hope.

The February employment situation will remain murky for some time, though, as extreme snowstorms in the Northeast and parts of the South and Midwest could cause a burst of temporary joblessness -- construction workers who weren't able to come to work, for example, or retail clerks whose employer shut down for several days.

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