Discount Rate at 3/4 Percent!

The news is that the Fed has increased the "discount rate" from its current level of 1/2 percent to 3/4 percent. Scott Sumner claimed that the Fed has shown its true stripes, offsetting the Obama administration's fiscal stimulus with a dose of monetary contraction. He blamed some losses in S&P futures on the move.

Thursday afternoon, my colleague said, did you hear that the Fed raised rates? I said, "what?" The Fed has been promising to keep rates low for an extended period of time. It is their odd (but directly out the the play book of orthodox macro theory) approach to dealing with the zero bound. She said, "they raised it 1/4 percent up to 3/4 percent." I said, "it was 1/4 percent before, isn't that a 1/2 percent increase." She said, "no.." I said, "oh, that must have been the primary credit rate. It's not important."

My local paper included the news in a small blurb in the back of the second section. That is where the business and economics news appears. Of course, the Wall Street Journal headline was "Rate Rise Stirs Questions." I just turned on the TV to check, and the stock market averages were up for the day.

It has been about seven years ago now that the Fed quit talking about the "discount rate," and instead began to call it the primary credit rate. The rate was to be pegged at one percent above the target for the federal funds rate. That would, of course, discourage banks from directly borrowing from the Fed. Instead, they would be more likely to borrow overnight from other banks at the lower, federal funds rate. Bank borrowing from the Fed was usually a few hundred million dollars.

In 2007, the Fed began to encourage banks to directly borrow. Perhaps the most remarkable action was to "jawbone" the four largest U.S. banks into borrowing $500 million each from the Fed on 22 August, 2007. The Fed had reduced the "penalty" on the primary credit rate from 1 percent to .5 percent a few days before. And then, in March of 2008, it reduced the penalty to .25 percent.

With the fed funds rate currently being targeted at a range from 0 to .25 percent, that .25 percent penalty made the primary credit rate .5 percent. And, now, the penalty is back to where it was in March of 2008, .5 percent. And so, the primary credit rate is now .75 percent.

As long the dollar is defined in terms of a unit of base money monopolized by the Fed, I believe the Fed should serve as "lender of last resort" to the banking system. What that means, however, is that the Fed should adjust the quantity of the monetary base to match increases in the demand by banks to hold reserves and other firms and households to hold currency.

There is no need for the Fed to ever make loans to particular banks, but rather it should simply purchase securities on the market. As long as there are government bonds with positive yields, it should purchase those. If those are gone, perhaps high quality private securities should be purchased next. If the Fed is running out of things to buy, then direct loans to banks may be necessary.

The danger of direct loans to banks is the Fed may seek to bail out politically influential, but insolvent banks. Raising the interest rate the Fed charges on direct loans to banks is a move away from the Fed's recent practice of making loans to banks.

Before the crisis, direct bank borrowing from the Fed was usually well below $1 billion. This was out of the nearly $800 billion of base money. The Fed created base money by purchasing government bonds. (It also made repurchase agreements, secured overnight loans to security dealers.)

During the crisis, the Fed increased direct lending to banks. Primary credit lending peaked at about $400 billion. However, it has dropped off rapidly, until slightly less than $100 billion of primary credit loans remain.

There were other sorts of lending to depository institutions that added another $300 billion at the peak, so that total lending by the Fed to the depository institutions peaked at $700 billion. However, total lending has now dropped to slightly more than $100 billion.

Suppose the increase in the primary credit rate should reduce this lending even more? Suppose it returns to the levels of before the crisis, of less than $1 billion?

The total monetary base is now approximately $2 trillion. The current level of Fed lending to banks is approximately 5 percent of the base. More importantly, the Fed can easily expand its purchases of Treasury bonds or mortgage-backed securities to offset the impact of any decease in lending to banks on the monetary base.

I believe that the Fed should stop targeting interest rates. The Fed should commit to increasing Final Sales of Domestic Product to $16.2 trillion by the first quarter of 2011. The Fed should announce that as the economy begins to recover, it fully expects all interest rates, including interbank lending rates, to rise substantially from their currently depressed levels. And while closing the discount window would be the first best solution, pegging the primary credit rate at one percent above a market-driven federal funds rate would be a step in the right direction.