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Markets Misread Fed's Rate Move as Central Bank Stumbles

The Fed probably can’t indulge in the good news-bad news dichotomy, but if it could, there’d be a lot less confusion about the meaning of the central bank’s discount rate hike in the financial markets.

Federal Reserve Chairman Ben Bernanke testifies before the Senate Banking, Housing and Urban Affairs Committee on his re-nomination to the position.
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Federal Reserve Chairman Ben Bernanke testifies before the Senate Banking, Housing and Urban Affairs Committee on his re-nomination to the position.

“Economic weakness isn’t exactly financial fragility,” says Robert Brusca, chief economist at FAO Economics. "It's a pretty big signal that the special conditions have ended."

In other words, the good news is that the financial system is in much better shape than it was a year ago; the bad news is that the economy is still struggling.

Or, in the context of the old cliché abut the Fed taking away the punch bowl just as the party is getting going, it's more like taking away the super-sized cups; you really weren’t going to drink it all anyway.

So, though economists say the timing of the Fed’s announcement to raise the rate to three-quarters of one percent may have spooked the markets, it’s more a technical, or mechanical, move than a policy one.

"It has really no operational impact," says Combinatorics Capital Managing Director Ram Bhagavatula of the quarter-point rate increase. "The Fed is saying. 'This is not a permanent subsidy,'" explains Bhagavatula. "It doesn’t make a lot of difference in terms of monetary policy."

Confusion in separating the condition of the real economy and the financial system at this stage should not be surprising; it was much the same during the end of 2007 and a good part of 2008 and even 2009.

In fact, the discount rate was one of the first tools the Fed turned to in August 2008, when it cut it by half a point; and things got a lot worse for quite a while after that. So, economists say, the change in the interest rate charged to commercial banks should be among the first tools or facilities to be adjusted.

“They made it very clear,” said Martin Feldstein of Stanford University and a former chief White House economist. “The markets are working now. If you need to get credit don’t come to the discount window.”

Others, however, saw a slightly more. "We need to also recognize that the Fed had a two-track policy," says David Jones of DMJ Advisors. "This move is a higly significant signal a series of exit moves are under way."

Nevertheless, the Fed—both current and former members—were forced into a damage control position to manage the confusion—and only with limited success.

Randall Kroszner, a former Fed governor, told CNBC early Friday morning that the hike was a “technical adjustment” and “not a policy decision.”

Kroszner, in fact, became a bit technical himself, adding that changes in the discount rate are decided by the Fed’s board of governors, not its policy–setting committee, known as the Federal Open Market Committee, or FOMC, and are often made outside of monetary policy meetings.

As true as that may be—and some economists say it’s somewhat debatable based on past actions—it makes the Fed's handling of the rate move, at best, a needless and ill-timed debate over style versus substance.

"The market is saying, 'What the heck is going on?' I think they could have been much more transparent," says Brian Bethune, chief US economist at Global Insight. "I can see them saying, 'This is just a technical thing, that it's not a big deal.' And it’s not. The blunder is in timing and communication; it’s the process, not the substance—which is very minimal."

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As the trading day progressed, the longer view appeared to have sunk in for the time being as stocks and bonds erased losses and essentially flatlined.

"The timing could have been better," says money manager Jim Awad, managing director at Zephyr Management. "Maybe over the weekend, so people had a chance to think about it."

The Fed, in fact, had previously mentioned the possibility of a discount rate hike, as well as the removal of other lending facilities as part of its planned exit strategy.

The blunder is reminiscent of the Bernanke Fed during the early days of the financial crisis when it was accused of surprising the markets unnecessarily, even if its policy actions were acceptable and understandable.

The near flawless communication and crisis management since then makes the discount-rate move even more mystifying to some Fed watchers.

“Given the way the Fed has been behaving—steadily, don’t rock the boat.” says Bethune. “To pull a surprise move was just a very bad idea. Now there’s speculation: Are they tightening? You start to open Pandora’s box.”