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Fed takes steps towards higher rates

THE US Federal Reserve last night took a major step towards a more normal monetary policy when it hiked the rate it charges banks for emergency loans.

In a surprise move announced after the stock market closed, America’s central bank increased the discount rate by a quarter percentage point to 0.75 per cent in response to “continued improvement in financial market conditions”.

The dollar hit a nine-month high against the euro of $1.3477 after the announcement.

And the pound fell to a nine-month low against the dollar at one stage.

It insisted that its first rate move since December 2008 would not raise borrowing costs for households and businesses. But financial markets took the move as hinting at a monetary policy tightening. The dollar jumped more than 1.3 per cent against the pound and pushed the euro to a nine-month low, while US stock futures and bond prices fell. Interest rate futures markets moved to price in a 68 per cent chance of a hike in the Fed’s main policy rate by September, up from 54 per cent. “Like the closure of a number of extraordinary credit programmes earlier this month, these changes are intended as a further normalisation of the Federal Reserve’s lending facilities,” the Fed said.

Its main policy tool, the federal funds rate, which governs overnight loans, is expected to stay between zero and 0.25 per cent in coming months as economic recovery remains fragile.

“The Fed can talk all day about how the discount rate hike is technical and not a policy move, but the market sees it as a shot across the bow. This may be one small step back toward the normalisation of Fed operations, but in the grand scheme of things, the Fed is moving back to doing business as normal. Today they raised the discount rate, and not tomorrow or the next day, but soon, they will be lifting the Fed funds rate target too,” said Chris Rupkey of Bank of Tokyo-Mitsubishi.

Before the crisis, borrowers at the discount window were charged a 100 basis point premium over the fed funds rate and could only borrow overnight. After Bear Stearns collapsed, that premium was slashed to 25 basis points and the maximum duration of loans was extended to 90 days. Last night’s rate hike takes the premium back up to 50 basis points.