Fed still likely to take its time in tightening

The Federal Reserve raised the discount rate last week. However, a hike in the federal funds rate is not likely to follow soon.

On 18 February, the Federal Reserve announced that it was raising the discount rate charged to banks for direct loans from 0.50 percent to 0.75 percent with effect from the following day. In addition, with effect from 18 March, the term of loans at the discount window reverts to being primarily overnight as compared to the maximum maturity of 90 days allowed during the financial crisis.

Although the discount rate was raised, the Fed said in a statement accompanying the move that it did not represent a tightening of monetary policy. Rather, it was a step towards "further normalization of the Federal Reserve's lending facilities" and does not signal any change in the outlook for the economy or for monetary policy.

Following the move, Fed officials at separate events said much the same thing.

In a speech to the Economics Club of Hampton Roads in Norfolk, Virginia, Federal Reserve Board Governor Elizabeth Duke pointed out that the discount rate "is not the rate we target for monetary policy purposes" and the rate hike is "not expected to lead to tighter financial conditions for households and businesses".

In a speech at the Augusta Metro Chamber of Commerce annual meeting, Federal Reserve Bank of Atlanta President Dennis Lockhart said that he "would not interpret this action as a tightening of monetary policy or even a sign that a tightening is imminent" but rather as "a normalization step".

Federal Reserve Bank of St Louis President James Bullard told reporters after speaking to the Economic Club of Memphis that the move is "part of a normalization process" and "does not indicate anything one way or the other about what we might eventually do with the federal funds rate."

Indeed, last week's economic data indicate that the Fed is unlikely to take actual tightening action soon.

A Labor Department report on Friday showed that inflation is unlikely to be a near-term concern for the Fed. While the headline consumer price index rose 0.2 percent in January and 2.6 percent in the preceding 12 months, the CPI excluding food and energy fell 0.1 percent and was up only 1.6 percent from a year ago.

And with the unemployment rate at 9.7 percent in January, just slightly lower than the peak of 10.1 percent in October last year, the Fed's expectation that substantial resource slack will restrain inflation is likely to be maintained in the near future.

Nevertheless, other data last week indicate that the economic recovery remains on track and that it is not too early to prepare for an eventual exit from the ultra-loose monetary policy initiated at the height of the financial crisis.

Reports last week show that the housing market may be stabilising. Housing starts rose 2.8 percent in January and the National Association of Home Builders/Wells Fargo index of builder confidence increased to 17 in February, the highest in three months, from 15 in January.

And while the unemployment rate remains near its peak in the cycle, the industry capacity utilisation rate increased to 72.6 percent in January from 71.9 percent in December, its seventh consecutive month of increase after the utilisation rate had fallen to a low of 68.3 in June last year.

Historically, the unemployment rate peaks soon after the industry capacity utilisation rate troughs, and is eventually followed by a series of increases in the federal funds rate.

Still, the Fed is likely to take its time in tightening monetary policy this time. It has made clear in the last few monetary policy meetings that even as it sees the economy improving, exceptionally low levels of the federal funds rate are likely to be warranted for an extended period.

Therefore, last week's data and the move on the discount rate are unlikely to lead to a hike in the federal funds rate soon.