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Fed’s rate boost challenges markets: Can they handle a tilt toward tighter credit?

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U.S. financial markets on Friday will face the first big test of life with just super-low interest rates -- as opposed to super-low-low rates.

The Federal Reserve on Thursday raised the interest rate it charges banks for emergency loans to 0.75% from 0.50%, while stressing that the change in the so-called discount rate was “not expected to lead to tighter financial conditions for households and businesses.” At least, not yet.

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The Fed didn’t raise its benchmark short-term rate – the “federal funds” rate – which it has kept between zero and 0.25% for more than a year. That’s the rate that directly and broadly affects consumer rates, including yields on bank deposits and the cost of loans.

In a statement, the central bank repeated its standard line of the last year, saying that it “anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

Still, markets were roiled in after-hours trading following the Fed’s late-afternoon announcement, as some investors saw the discount-rate hike as a sign that the central bank was serious about pulling back somewhat on its easy-money policies as the economy revives.

The dollar shot higher against the euro and other currencies, because higher interest rates tend to make a nation’s currency more attractive to global investors. Yields on shorter-term Treasury securities rose, with the two-year T-note hitting a five-week high of 0.96%, up from 0.85% on Wednesday.

“The Fed can talk all day about how the discount rate hike is technical and not a policy move, but the market sees it as a shot across the bow,” said economist Chris Rupkey at Bank of Tokyo-Mitsubishi UFJ.
Fed officials, including Chairman Ben S. Bernanke, have signaled in recent weeks that they were focusing on how to wean the financial system off the extraordinary aid the central bank has provided since the credit crisis exploded in late 2008.

Their shift isn’t a surprise, and it’s a sign that the financial system, and the economy, are on much firmer ground.

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In its statement Thursday, the Fed said the boost in the discount rate, and other “modifications” it was making to some of its lending programs, were intended to encourage banks “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 Fed used a word it will be repeating a lot in coming months: “normalization.” It isn’t normal to have short-term interest rates at zero, and it isn’t normal for the Fed to have purchased $1.25 trillion of mortgage-backed bonds to keep home loan rates down. “Normalization” will mean gradually retreating from the emergency steps the Fed took to bolster the financial system and the economy.

But one risk is that stock, bond and currency markets could overreact in the short-term to any sign of tighter credit, no matter how modest. Severe market disruptions could force the Fed to halt its normalization moves for fear of threatening the economic recovery.

The ball now is in the markets’ court.

-- Tom Petruno

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