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Exit Strategy – Step One Begins.
On February 18, 2010, in a mildly surprising move, the Federal Reserve Board began its long awaited exit strategy. By raising the discount rate by 0.25% to 0.75%, the Fed gave a clear signal that it has begun the long process of draining financial liquidity from the system albeit in a small but significant way. (The discount rate is the rate the Fed charges large banks when they need temporary funds in a hurry.) This discount rate move does not affect the federal funds rate, a more important Fed tool that controls the rate that banks charge each other on overnight loans.
This is a good news/bad news event. The good news is the Fed thinks the economy is slowly improving. The bad news is the Fed thinks that economic growth will accelerate soon and, therefore, it must begin this first small step for mankind to prevent the economy from growing too fast. That also means that short term interest rates will begin to rise. And, they have.
This is also a bit of positive news for millions of people who have funds in money market funds and bank accounts. They will see a small rise in the interest paid on their money. It’ll be miniscule to be sure, but heck a 0.25% rate is better than zero!
Looking Ahead
The Feds task of draining liquidity in the months ahead will not be easy. The United States economy is now a $14 trillion behemoth that must be maneuvered carefully and delicately. The typical analogy is that of a huge ocean liner — like a Super Ship. Our Super Ship is slowly picking up speed because the boilers have been stoked. The Captain (Bernanke) now fears that rough shoals may lie far ahead and the ship must be held in check now rather than later when it may be moving too fast.
We applaud todays Fed action. It is a careful, calculated, step and a significant one. Most rational economists will agree with this move. It should not jar the markets to any great extent. Our fundamental stance for the next year or two remains the same. It’s still a bull market and it ain’t over yet.
