The Fed has been talking about its "exit strategy" for quite some time. Few believed he would pull the trigger on anything soon. Yet, Bernanke, unexpectedly raised the discount rate headed into options expiration.



Please consider the Federal Reserve Discount Rate Announcement released after the market close on February 18, 2010.



The Federal Reserve Board on Thursday announced that in light of continued improvement in financial market conditions it had unanimously approved several modifications to the terms of its discount window lending programs.



Like the closure of a number of extraordinary credit programs earlier this month, these changes are intended as a further normalization of the Federal Reserve's lending facilities.



The changes to the discount window facilities include Board approval of requests by the boards of directors of the 12 Federal Reserve Banks to increase the primary credit rate (generally referred to as the discount rate) from 1/2 percent to 3/4 percent. This action is effective on February 19.



In addition, the Board announced that, effective on March 18, the typical maximum maturity for primary credit loans will be shortened to overnight. Finally, the Board announced that it had raised the minimum bid rate for the Term Auction Facility (TAF) by 1/4 percentage point to 1/2 percent. The final TAF auction will be on March 8, 2010. ....



The increase in the discount rate announced Thursday widens the spread between the primary credit rate and the top of the FOMC's 0 to 1/4 percent target range for the federal funds rate to 1/2 percentage point. The increase in the spread and reduction in maximum maturity 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 Federal Reserve will assess over time whether further increases in the spread are appropriate in view of experience with the 1/2 percentage point spread.



Unsustainable Course

No Short Cuts



Finally, there are no short-cuts. We currently must adjust from a misallocation of resources. There is no way to avoid some short-term pain in fixing the fundamentals in our economy. It is inconvenient for the election cycle, and it is undeniably terrible to have at least 10 percent of the labor force out of work. But short cuts now mean people out of work again in only a few years because we again try and avoid difficult adjustments. Outlining a credible course for managing our debt for the future will accelerate the restoration of confidence in our economy and contribute importantly to sustainable capital investment and job growth.



Conclusion



As I mentioned in the beginning, the fiscal projections for the United States are so stunning that, one way or another, reform will occur. Fiscal policy is on an unsustainable course. The U.S. government must make adjustments in its spending and tax programs. It is that simple. If pre-emptive corrective action is not taken regarding the fiscal outlook, then the United States risks precipitating its own next crisis. ...



The only difference between countries that experience a fiscal crisis and those that don’t is the foresight to take corrective action before circumstance and markets harshly impose it upon them. In time, significant and permanent fiscal reforms must occur in the United States. I much prefer this be done well before anyone feels an irresistible impulse to knock on this central bank’s door.

Treasuries Decline After Announcement

Treasuries declined after the Federal Reserve raised the discount rate charged to banks for direct loans for the first time in more than three years to encourage financial institutions to rely less on the central bank for short-term borrowing.



“This is all about how to start draining excess reserve and implementing a tighter policy,” said Jay Mueller, who manages about $3 billion of bonds at Wells Fargo Capital Management in Milwaukee. “It’s not overtly hawkish, but not an indication of perpetual dovishness or accommodation. This is a necessary step before they could do the rest of the sequence of events.”



The rate increase is another step in the Fed’s gradual retreat from its unprecedented actions to halt the deepest financial crisis since the Great Depression. The central bank has provided hundreds of billions of dollars in backstop credit to banks, bond dealers, commercial paper borrowers and troubled financial institutions such as American International Group Inc.



Fed Chairman Ben S. Bernanke and policy makers “have reiterated in every way that this does not signal a change in policy,” said Aaron Kohli, an interest-rate strategist at primary dealer Royal Bank of Scotland Group Plc in Stamford, Connecticut. “This is a normalization of policy. They worked hard to remove the stigma from the discount window, and now they are normalizing the rate.”

Change In Policy?

Slow Steps Expected

What Does It Mean?

Important Takeaway