February 23rd, 2010 9:05 AM by Mel Samick
The Federal Reserve boosted the discount rate from 0.50% to 0.75%, the first such hike in three and half years. The move was claimed as a technical adjustment to increase the spread over an unchanged federal funds rate target. The stock market also responded in a surprisingly positive mood and the Dow closed up last week. The Fed emphasized that its decision was not a signal for any change in economic or monetary policy and that it is still intent on keeping money easily accessible. The discount rate is what the Fed charges banks that borrow from them when liquidity is required. The discount rate is not to be confused with the fed funds rate, which determines the price of short-term credit throughout the economy. When put in context, the discount rate is still considered low relative to the fed funds rate (between 0% and 0.25%) which is typically a full percentage point lower than the discount rate. The discount move was considered overdue, given the return to relative health of the overall financial system.
In another change of course, Chinese appetites for Uncle Sam's debt seem to be waning. According to new data released last Tuesday morning by the Treasury Department, foreign holdings of U.S. Treasury securities plunged by $53 billion in December, a record drop. China led the sell-off, reducing its holdings by $34 billion. Japan, meanwhile, increased its holdings by $11 billion to become the new largest foreign holder of Treasuries. As of the end of December, Japan held $768 billion of U.S. government debt, followed by China at $755 billion, and then Great Britain at $302 billion. In the last year there have been consistent concerns that China and other nations might reduce their holdings of U.S. government debt as the U.S. continues to rack up record deficits in the wake of the recession. If foreigners were to undertake a massive unloading of U.S. Treasuries, the country could have to make available higher interest payments to entice other would-be participants. However, it may still be a pre-mature conclusion based only on one month's worth of data.
The sudden spotlight on troubled government borrowers in the Euro zone is presenting an opportunity for hedge fund investors who placed early bets against countries now under pressure. In Europe, many countries are experiencing troubles due to excessive sovereign debt. In particular, there are problems in Portugal, Ireland, Italy, Greece, and Spain (thus the acronym "PIIGS"). So, in a way, some hedge funds are planning to feast on "PIIGS". What is the source of the problems? The standard explanation for the problems in some of the countries, e.g. Greece, is that lack of effective monitoring of government deficits within Euro-area countries and lack of enforcement of the rules on how much debt a country can carry, allowed excessive debt levels to accumulate. In other cases, such as Spain, the problem wasn't irresponsible budget behavior, it was the recession that caused the government budget to collapse. Thus, the problems were generated both by bad behavior and by bad luck, and as it turned out, once these countries got into trouble, the deficit problems were made worse by the fact that countries within the Euro area do not have the ability to utilize independent monetary policy. If these countries had their own currency, they could devalue and stimulate exports and this would then offset the negative effects from raising taxes or cutting spending to address the deficit problem. But that option is subsequently not available to them.
The International Monetary Fund has long preached the virtues of keeping inflation low and allowing money to flow freely across international boundaries. But two recent research papers by economists at the IMF have questioned the soundness of that advice, arguing that slightly higher inflation and restrictions on capital flows can sometimes help buffer countries from financial turmoil. One paper has received particular attention for suggesting that central banks should set their target inflation rate much higher -- at 4 percent, rather than the 2 percent, which is the most widely held standard. This paper is getting more attention amongst economists and some are concerned that the U.S. and Europe's near-zero-policy interest rates are fueling a surge of international capital into Asia and Latin America that will end in more problems if not properly managed. Who knows, this may be a time to challenge the traditional approach .