Yesterday evening the Federal Reserve announced that it was raising the interest rates on discount window loans from 0.50 percent to 0.75 percent. Investors apparently (and Matt Yglesias definitely) reacted to this news as if the Fed were significantly tightening the money supply.
It’s not, though. The discount window traditionally is not a tool the Fed uses in its capacity as monitor of the money supply. It is an instrument for the Fed as lender of last resort. When financial institutions are illiquid but not insolvent, meaning they have trouble getting credit from banks even though they are financially sound, they can borrow from the Fed at a reduced rate for a short period of time until they can prove to the market that they are solvent. Generally firms avoid borrowing directly from the Fed. In fact, in the early stages of the financial crisis the Fed had to take unusual steps to get banks to borrow from the discount window at all, because nowadays doing so sends out such a bad signal.
The point is, though, that the discount window rate has been held especially low for financial stability reasons, not monetary reasons. And it’s not as if Bernanke has been confusing about his plans for this particular rate. In the most recent Federal Open Market Committee meeting, the Fed reached a consensus that it would “soon be appropriate” to increase the discount window rate. The New York Times article linked above has an illuminating quote from Macroeconomic Advisers’ Laurence Meyer, who’s also a former Fed governor: “If the markets respond to this on Friday, it will reflect a total lack of comprehension of what the chairman said…. Don’t they understand the meaning of soon?”
When the Fed wants to increase or decrease the money supply, its usual preferred tool is targeting the federal funds rate. It’s understandable, although odd, that investors or commentators would confuse movements of the discount window rate with movements of the federal funds rate. What’s especially confusing, though, is that Bernanke has gone out of his way to make it clear that in the wake of the Fed’s extraordinary monetary measures enacted during the recession, the Fed will first target the interest rate paid on reserves at the Fed to tighten the money supply, not the federal funds rate.
So slightly increasing the discount window rate is technically a contractionary move, but in terms of overall tightening, which Bernanke has signalled should begin only toward the end of 2010, it’s a fairly negligible change in policy. That market actors have responded to the Fed’s announcement by selling stocks and driving the dollar up indicates that they don’t understand the very clear plan the Fed has outlined. And Yglesias’s complaints that “the Fed has decided it wants to slow down growth” and that “the Fed moved to tighter money and the markets are reacting” suggests that he doesn’t fully comprehend the Fed’s plan either.