Federal Reserve raises discount rate, what does it mean for us?
In a surprising and underhanded way, yesterday after the market closed the Federal Reserve raised the discount rate from .50% to .75%! Before we get into what this means, the fact that a major policy change was announced just before the third Friday of the month leaves much to be desired. This is because all third Fridays are option expiration days and the market always reacts violently to any unexpected decision from the Fed. Although today's market open looks rather timid overnight futures were showing significant losses and I bet some people who were positioned long were thinking of creative ways to water board Bernanke and set fire to the Federal Reserve building.
So what is the discount rate? This is the rate that the central banks charge for doing business with the member banks if the member banks need cash. If you were to imagine the entire Federal Reserve structure it is a giant pyramid. On top sits the main Federal Reserve and under him are smaller Reserve banks. Under those are the major commercial banking powers that comprise the reserves of the Reserve banks. Under the commercial banks are smaller regional banks that do business with the commercial banks. As money trickles down the pyramid it eventually enters our system in the form of credit and is dispersed into every corner of our economy. The cost of doing business between the central and commercial banks is known as the discount rate, although it is comprised of smaller individual rates let us keep this definition for now. Therefore the higher the discount rate the more expensive it becomes for banks to lend to each other assuming they need money from the lender of last reserve (the Fed). This has nothing to do with your interest rates that you receive from the bank nor does it affect the cost of your loans, this is strictly an inter-banking rate and one that is not used commonly. Still, it can be beneficial to draw correlations between the discount rate and a general mood of credit expansion.
Because our economy is primary credit driven the amount of credit outstanding is correlated with economic activity. As credit expands; investments expands, jobs are plentiful, speculation rises, prices spike, irrational exuberance and general idiocy ensues. As credit contracts; investments shrink, employers cut, unemployment rises, stocks drop and a general feeling of malaise hits the country. Some might call it a depression, some might refer to it as a junky going through withdrawal - both would be accurate.
Below I have superimposed two charts for you. One is the discontinued discount rate on top of the non-revolving credit. I could not find the latest discount rate data, but this will suffice (I have taken the liberty of drawing in the last 5 years). We could have also used any other credit indicator, but you will get the general idea.
On top is the discount rate and on the bottom is the total non-revolving credit. I shifted the bottom chart a bit because it takes some time for central bank policy to take effect, there is always a lag before the general economy responds to major shifts. This is why virtually all government actions are useless as they are delayed for too long to be effective, but I digress. Look carefully and you will observe that lowering of the discount rate coincides with expansion of credit, the black lines depicting a pause or hike in the discount rate lowering and red lines depicting lowering. As credit contracts the central bank starts to lower the discount rate as can be seen around the recession periods (gray areas), however rates are lowered and kept low as credit expansion picks up. Observe what effects the central bank has on our credit behavior. Notice that rates go up into recessions? Mind you a more convincing chart would be to tie the interest rates and overall credit (something you can find here), but even this correlation exposes the impact of rates on credit and credit's impact on the gengeral economy.
Reason being is that we have central planning when it comes to the price of money. Because our economy is run by a select group of elite and powerful people they sometimes overstay their welcome and make mistakes. The reason that rate hikes coincide with recessions is because the amount of credit in the system exceeds what is truly needed and this excess was often created by the Federal Reserve during it's previous rate lowering campaign. By the way, it should be of no surprise to you that since 1980s the amount of effort needed to stimulate the credit creation process has been increasing. As an aggregate rates have been going lower and lower and have stayed at unreasonably low rates for longer periods of time. The 1970s were somewhat of an anomaly because the dollar went completely fiat and inflation was out of control, this is why you see such massive spikes in rates. However since the 1980s and largely under Greenspan's new economy, the answer to all recessions and contractions was to flood the system with more cheap money.
So what does the recent rate hike tell us? If you look at the chart again, it would appear that expanding overall credit was a failure in the past several years. This is why you continue to see high unemployment, bankruptcies and a sluggish economy despite what the bobble heads on TV are trying to say. Instead the only thing our Federal Reserve accomplished was to ignite another asset bubble in the stock market. This is a rather common occurrence during prolonged periods of credit expansion, money flows into speculative areas like stocks and real estate. It happened in the late 20s, 80s, 90s and today, and each time the market collapsed as the credit rug gets rudely yanked out. Some of the ruling elite has realized this and began to change their posture from easy to money to tighter money. Unfortunately for them our economy is still in the dumps and possibly getting worse, the only reason why a full blown depression/contraction has not set in is because it is being propped up by funny money. Yet this funny money is accomplishing diddly squat and instead is poised to cause more damage! Hoover and FDR tried desperately to direct credit to areas of growth while demonizing Wall St, yet they were trying to do the impossible. History is repeating itself as Obama and the Democrats are desperately seeking more money for businesses in a futile attempt to experience another expansion. Sorry folks, does not work like that. You can't make banks lend when there is NOBODY TO LEND TO and you can't make people take on more debt when they are neck deep in debt already.
To me, this change in policy signifies that at least somewhere someone gets it. Liquidity has failed and any further liquidity will only threaten to make the asset bubble bigger. Of course a .25% discount rate hike is small potatoes compared to what the Fed SHOULD be doing. We need the general interest rate to go up starting now and we need a massive reduction in government spending and we sure as hell cannot monetize any more debt. Yes this will be more pain, more unemployment and more bankruptcies, but it absolutely has to happen if America wants to escape from these socialist shackles that have been imposed upon her.
Note: If you are wondering what the hell happened in 2000s and why there is a big OOPS in the chart, it basically comes down to the Fed intervening badly into what should have been a contracting economy. As you can see credit was shrinking and it was doing so because it was trying to work the excess out of the economy (a chart showing total credit accumulation can be found here). A contraction is painful as we discussed and Greenspan decided to kick the can down the road. Unfortunately most of the money and credit went into housing creating a bubble of insane proportions, but affected school loans, cars and appliance sectors as well. This is why everyone felt that life under Bush became worse! They were very much correct in their feeling, but many have no idea where the hardship is coming from. A mass education and taking control of our banking and finance sector is absolutely imperative to restore sanity.
So what is the discount rate? This is the rate that the central banks charge for doing business with the member banks if the member banks need cash. If you were to imagine the entire Federal Reserve structure it is a giant pyramid. On top sits the main Federal Reserve and under him are smaller Reserve banks. Under those are the major commercial banking powers that comprise the reserves of the Reserve banks. Under the commercial banks are smaller regional banks that do business with the commercial banks. As money trickles down the pyramid it eventually enters our system in the form of credit and is dispersed into every corner of our economy. The cost of doing business between the central and commercial banks is known as the discount rate, although it is comprised of smaller individual rates let us keep this definition for now. Therefore the higher the discount rate the more expensive it becomes for banks to lend to each other assuming they need money from the lender of last reserve (the Fed). This has nothing to do with your interest rates that you receive from the bank nor does it affect the cost of your loans, this is strictly an inter-banking rate and one that is not used commonly. Still, it can be beneficial to draw correlations between the discount rate and a general mood of credit expansion.
Because our economy is primary credit driven the amount of credit outstanding is correlated with economic activity. As credit expands; investments expands, jobs are plentiful, speculation rises, prices spike, irrational exuberance and general idiocy ensues. As credit contracts; investments shrink, employers cut, unemployment rises, stocks drop and a general feeling of malaise hits the country. Some might call it a depression, some might refer to it as a junky going through withdrawal - both would be accurate.
Below I have superimposed two charts for you. One is the discontinued discount rate on top of the non-revolving credit. I could not find the latest discount rate data, but this will suffice (I have taken the liberty of drawing in the last 5 years). We could have also used any other credit indicator, but you will get the general idea.
Reason being is that we have central planning when it comes to the price of money. Because our economy is run by a select group of elite and powerful people they sometimes overstay their welcome and make mistakes. The reason that rate hikes coincide with recessions is because the amount of credit in the system exceeds what is truly needed and this excess was often created by the Federal Reserve during it's previous rate lowering campaign. By the way, it should be of no surprise to you that since 1980s the amount of effort needed to stimulate the credit creation process has been increasing. As an aggregate rates have been going lower and lower and have stayed at unreasonably low rates for longer periods of time. The 1970s were somewhat of an anomaly because the dollar went completely fiat and inflation was out of control, this is why you see such massive spikes in rates. However since the 1980s and largely under Greenspan's new economy, the answer to all recessions and contractions was to flood the system with more cheap money.
So what does the recent rate hike tell us? If you look at the chart again, it would appear that expanding overall credit was a failure in the past several years. This is why you continue to see high unemployment, bankruptcies and a sluggish economy despite what the bobble heads on TV are trying to say. Instead the only thing our Federal Reserve accomplished was to ignite another asset bubble in the stock market. This is a rather common occurrence during prolonged periods of credit expansion, money flows into speculative areas like stocks and real estate. It happened in the late 20s, 80s, 90s and today, and each time the market collapsed as the credit rug gets rudely yanked out. Some of the ruling elite has realized this and began to change their posture from easy to money to tighter money. Unfortunately for them our economy is still in the dumps and possibly getting worse, the only reason why a full blown depression/contraction has not set in is because it is being propped up by funny money. Yet this funny money is accomplishing diddly squat and instead is poised to cause more damage! Hoover and FDR tried desperately to direct credit to areas of growth while demonizing Wall St, yet they were trying to do the impossible. History is repeating itself as Obama and the Democrats are desperately seeking more money for businesses in a futile attempt to experience another expansion. Sorry folks, does not work like that. You can't make banks lend when there is NOBODY TO LEND TO and you can't make people take on more debt when they are neck deep in debt already.
To me, this change in policy signifies that at least somewhere someone gets it. Liquidity has failed and any further liquidity will only threaten to make the asset bubble bigger. Of course a .25% discount rate hike is small potatoes compared to what the Fed SHOULD be doing. We need the general interest rate to go up starting now and we need a massive reduction in government spending and we sure as hell cannot monetize any more debt. Yes this will be more pain, more unemployment and more bankruptcies, but it absolutely has to happen if America wants to escape from these socialist shackles that have been imposed upon her.
Note: If you are wondering what the hell happened in 2000s and why there is a big OOPS in the chart, it basically comes down to the Fed intervening badly into what should have been a contracting economy. As you can see credit was shrinking and it was doing so because it was trying to work the excess out of the economy (a chart showing total credit accumulation can be found here). A contraction is painful as we discussed and Greenspan decided to kick the can down the road. Unfortunately most of the money and credit went into housing creating a bubble of insane proportions, but affected school loans, cars and appliance sectors as well. This is why everyone felt that life under Bush became worse! They were very much correct in their feeling, but many have no idea where the hardship is coming from. A mass education and taking control of our banking and finance sector is absolutely imperative to restore sanity.
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