Friday, February 19, 2010

Discount Rate Hike is no Surprise

The announcement late yesterday that the Federal Reserve was raising the discount rate by 25 basis points to 0.75% came as a surprise to many investors. It shouldn't have. The Fed has been broadcasting its intentions for several weeks. For example, in its Jan. 27 press release, the Fed said, "economic activity has continued to strengthen." This was the strongest statement yet from the Fed that the crisis is over. And just a week ago, Chairman Ben Bernanke actually said in a speech that the Fed might raise the discount rate. So yesterday's action should have been fully anticipated. It should also be seen as good news. Extremely low interest rates are not good for the economy. They signal a continuing crisis. Yet the Fed has been trying to convince investors for quite some time that the worse is over. It finally figured out that actions speak louder than words. By raising the discount rate, the Fed is signaling that it actually believes what it is saying. The Fed may deny it, but it will probably start raising the more important fed funds rate before long. Contrary to popular opinion, stocks will probably hold up well on the news. A modest increase in the fed funds rate should give investors confidence that the economy really is getting stronger.