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.
