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February 2010
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Fed Reserve Raises Interest Rates

In subprime mortgage debacle and financial crisis, the Federal Reserve urged the national banks to step up to its discount window, pushing the banking industry to get over the stigma on borrowing from the government. When banks and finance companies stopped lending to each other overnight altogether in the fall of 2008, discount window for home mortgage loans became even more crucial. The Fed even narrowed the penalty banks paid for using discount window money, moving the discount rate closer to the Federal funds rate during the crisis.

Watch Video on the Fed Raising the Discount Rate

According to mortgage executive, Bryan Dornan, “Clearly, the Fed is signaling a change in direction for interest rates.”  Dornan continued, “Now that the Fed is raising rates, expect mortgage rates to begin retreating upwards.” Now that the crisis has blown over, the Federal Reserve wants things to get back to normal. Late Thursday afternoon, it surprised the markets by raising the discount rate it charges though its emergency window to 0.75% from 0.50% while keeping its targeted Federal funds rate at between zero and 0.25%. The change will take effect on Friday. Meanwhile, the duration of the mortgage loans will revert to the normal overnight period from 30 days come mid-March. Though many thought the Fed was headed in this direction, most everyone thought it wouldn’t act until its next Open Market Committee meeting next month.

The Fed explained in a brief statement that it wants banks to return to the private debt markets. The increase “will encourage depository institutions to rely on private funding markets for short-term credit and to use the Federal Reserve’s primary credit facility only as a backup source of funds.” The central bank added the move was not a signal it was tightening money nor a signal its outlook on the economy had changed. It is a further indication; however, that the government is pulling away from the extraordinary assistance it has given the financial markets over the last few years.

Later this spring the Fed is expected to stop buying bad credit mortgages and mortgage-backed securities, a move that is worrying those in the housing markets who had hoped for a smooth recovery. The government’s numerous bank industry lifelines have been criticized for allowing banks to make heaps of money by borrowing from the Fed at next to nothing and profiting from the spreads they can make by investing that cash in the Treasury markets. But the Fed also has to come up with an exit strategy for a balance sheet that has become bloated with Wall Street’s unwanted assets. Forcing banks back to the short-term debt markets for funding (or even to rely on their own deposit taking operations) is another baby step to getting the banks out of the emergency safety net.