How to interpret the Fed's latest move...

The Fed caught everyone by surprise with their decision to hike the discount rate by 25 basis points right after the U.S. market close last night. Markets reacted negatively, whilst the dollar continued to strengthen.

As a reminder, the discount rate is the rate that the Fed charges banks that want to borrow directly from it. When the crisis began in 2007, the Fed embarked on an aggressive rate cutting process. The discount rate eventually settled at an unusually low 0.5% towards the end of 2008, whilst the target rate (a main tool for setting monetary policy), which is the rate the Fed sets for inter-bank federal funds lending, dropped to a low of 0.25% around the same time. At the time, there was no sense in cutting rates any further as a so called liquidity trap had formed, whereby the stimulus effect of cutting rates any further had effectively become null.

So what is the message behind the move? My interpretation would be that this change marks the beginning of the end of the emergency support to the financial system. I doubt very much that tightening of the target rate will come any time soon. There is still a lot of damage out there and the economy is still a long way away from being able to walk about without government crutches. This move effectively paves the way for additional withdrawals of support. I expect quantitative easing to be one of the next major candidates on the list.

The burden of uncertainty

It is a well known fact that one of humankinds greatest burdens has to do with uncertainty, and just like its distant cousin, infinity, our minds have a difficult time coping with the concept. Countless studies have shown, for example, that we are much happier once something that was uncertain becomes certain, even if it happens to be something unpleasant. Apparently the mere presence of certainty removes a whole layer of tension.
Markets behave in a very similar manner and the degree of uncertainty can easily be measured by the degree of volatility. It is why in times of serious trouble, as in the second half of 2008, volatility levels can rise dramatically.
As uncertainty is perceived to be an unpleasant experience, it acts as a powerful driver that pushes us to come up with solutions to counter it. The insurance business is a perfect example of an industry that has flourished as a direct result of mankind's desire to counter uncertainty. Corporate earnings announcements is another example whereby the time frame between earnings reports have been shortened in order to reduce the degree of uncertainty regarding the health of a business. Such strategies do come at a price, however. By increasing the frequency of earnings results in a given year, the firm may be sacrificing long term objectives for short term gains.
With all this in mind, the EU's willingness to bail out Greece and Abu Dhabi's intervention on Dubai should come as no surprise. In both cases it would seem that the uncertainty of doing nothing is just too large of a burden to cope with.

A fluke or for real?

Last week's announcement that the U.S. economy had expanded in the fourth quarter (the second consecutive expansion) by a greater amount than what the market consensus expected took everyone by surprise, raising the risk that the resulting complacency may lead to a premature withdrawal of some of the more critical stimulus plans in place.

The trouble stems from the nature of the downturn which in this case is structural rather than cyclical. Historically speaking, it takes an economy significantly longer to recover from a structural downturn than a cyclical one. The combination of greater government regulation in an environment of high unemployment and weak consumption can only contribute to extending the period of slump. The stock market rally in 2009 may reflect a disconnect between expectations and the real fundamentals and, as a consequence, stocks may disappoint this year.