February 19, 2010
Late yesterday after US financial markets had closed, the Federal Reserve Bank announced that it will raise the discount rate by a quarter of one percent from .50% to .75%. The discount rate is what the Fed charges for short-term loans to banks. Overnight, stock and bond markets in Asia and Europe have reacted by moving sharply lower, and a lower open is expected for Wall Street this morning. To see stocks fall on news of higher rates is not a big surprise. After all, conventional wisdom says, if you can make money keeping your cash in a savings account, why buy a stock and take the risk? And so the Chicken Littles of the world once again have a day in the sun as they sell, fearing higher rates, higher inflation, maybe even a surge in the popularity of disco music.
They are wrong. A look at facts shows why. Let's start with this: we are emerging from recession and a highly unusual period of market panic. Rates for short-term money are at historic lows, driven down over the last 18 months by a Federal Reserve anxious to avoid collapse of the US economy. So a rise in rates from near zero to less than 1% does not exactly portend hyperinflation. In an inflationary environment, prices and interest rates rise continuously and investors are unsettled that their future purchasing power will shrink, so they demand ever-higher returns, continuing the spiral. Now its time for the Fed to unwind some of the emergency measures taken in late 2008 and early 2009 when we were on the brink of a yawning chasm of financial fear. Part of the reason for the extra-low-rate environment was to help repair the banks that had lent money to people who can't pay it back. Now the banks are awash in profits and repaying their generous bailouts (and giving themselves huge bonuses for practically wrecking our economy - thanks, guys).
Nobody's happy to see interest rates rise. But take heart: the modest rise that we can expect over the next couple of years is a sign of economic recovery and health. A selloff today - if we get one - is not likely to have lasting effect.
(This article contains the current opinions of the author but not necessarily those of Brighton Securities Corp. The author's opinions are subject to change without notice. This blog post is for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities).