The sharp financial market reaction to the Federal Reserve's discount rate increase — despite its assurances that the hike is not monetary tightening — shows the tricky communication task officials face as they tiptoe toward an eventual change in rate policy.
The Fed's announcement on Thursday that it was increasing the rate it charges banks for emergency loans to 0.75 percent from 0.50 percent knocked down global stocks and commodity prices and pushed up the U.S. dollar.
It prompted futures traders to boost bets the Fed will raise its benchmark short-term interest-rate target by September, even though the Fed signaled it is still committed to holding that rate ultra low for "an extended period."
"To some extent, the market's reaction must be quite perturbing to the Fed," said Alan Ruskin, head of currencies for RBS Global Banking and Markets in Greenwich, Connecticut.
"The concern from the Fed must be, 'Now what happens when we really want to do something substantive?'"
It was the first increase in lending rates by the U.S. central bank since it lowered its target for overnight interbank borrowing rates, its main policy lever, to near zero in December 2008 to battle a deep recession and severe financial crisis.
Fed Chairman Ben Bernanke said just last week the central bank would soon consider raising the discount rate, but the timing of the move still caught markets off guard.
Usually, the discount rate would move in lock-step with the interbank federal funds rate.
Bernanke also took pains to explain a discount rate hike would signal only a return to more normal conditions, not a change in monetary policy.
But markets did not fully heed the message.
"We always have a communication challenge," New York Federal Reserve Bank President William Dudley told reporters on Friday.
"There are people sitting at their desk looking at the screens all day long who are extremely knowledgeable and know exactly what's going on and there are those that just casually see the headline in the newspaper and don't have a way of evaluating what that discount rate increase means."
Dudley, along with St. Louis Fed President James Bullard, Atlanta Fed chief Dennis Lockhart and Fed Governor Elizabeth Duke, were quick to reiterate the central bank's position that raising the discount rate is not the same as broadly boosting borrowing costs.
"I would not interpret this action as a tightening of monetary policy or even a sign that a tightening is imminent," Lockhart said on Thursday.
The fragility of the economic recovery, and the need for continued low rates to support it, is a topic that Bernanke is likely to address next week in semiannual testimony to Congress.
With the U.S. unemployment rate at a lofty 9.7 percent and ample spare capacity at factories, Fed officials do not see an imminent inflation risk that would warrant higher borrowing costs for businesses and consumers.
A government report on Friday showed consumer prices excluding volatile food and energy costs fell in January for the first time since 1982, bolstering the Fed's low-rate case.
But even after the calming inflation news, federal funds futures contracts still suggest traders see a higher likelihood of an interest-rate increase by September than they did before the Fed's announcement.
The markets' reaction "shows the limitations in just how much you can smooth out the kinks in the way the market receives information," Ruskin said.
Michael Pond, a bond market strategist at Barclay's Capital in New York, said the Fed may have been trying to "test the markets."
"There are occasions when the Fed wants to surprise the markets," he said.
"They learned a lesson back in 2004 to 2006, that providing too much certainty led to the market taking on too much risk."
Ruskin said, however, that Thursday's sharp market reaction showed how careful the Fed would need to proceed when it eventually feels the time is right to begin tightening monetary policy.
"The reaction from yesterday is testament that they will have to be quite deft in their flagging of tightening, when they actually do tightening," he said.
"As they then progress," he added, "it becomes less imperative that they flag every move."
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