What the Federal Discount Rate Means to You
Since last July, Alan Greenspan, chairman of the board of the Federal Reserve, has been telling Congress that he must slow down the economic expansion because it is over-heating. On August 26, 1999, he raised the discount rate from 4.50% to 4.75%. November 17, 1999 he raised it from 4.75% to 5.00%. Again, February 4, 2000 he raised it from 5.00% to 5.25%.
The discount rate to banks is what banks pay to the Feds for money. When the Fed raises their interest rate, banks then raise their prime interest rate to their borrowers.
When Alan Greenspan raises the discount rates, it sends shivers through the stock market. August 25, 1999, the day before he raised the interest rates for the first time last year, the stock market was 11,334. After the other two raises on November 17th, and February 4th; as of 12:00 on February 29th, the stock market was 10,055. This is a 1,279-point drop.
A lot of things affect the stock market, however, it seems that the discount rate to banks affect it more than other variables. This does not mean run and sell out of the stock market, it only means that watching the discount rate to the banks could be helpful in guessing where you think the stock market is headed.
Alan Greenspan said he would not let stock prices rise faster than household income. He claims that stock prices growing at the rate they have grown, creates what he calls “the wealth effect”. If we believe we are wealthy, then we will spend more money, which in turn heats up the economy. I can’t find any economists that understand what household income has to do with stock prices. It seems to be a very controversial subject. When you consider the very small percentage of the US population that is investing into the stock market, it is hard to understand how “the wealth effect” could cause inflation. If “the wealth effect” is a real problem, then why hasn’t inflation risen? We have just experienced the longest period of an expanded economy without inflation in US history. The stock market has soared, unemployment has gone down and all of this without inflation. However, Mr. Greenspan now says it is over. He will stop the stock market from growing and raise the unemployment rate. If Mr. Greenspan has his way, stocks will not go up and could even go down further. Alan Greenspan cannot point to any inflation today. He simply says there is an underlying inflation that will show up if he does not put a halt to the economy.
The Federal Reserve has always used the discount rate to banks to push, pull, stop and start the economy. They have always known that they could push the economy off into a recession if they raised the discount rate enough. A recession does stop inflation, however, raising interest rates is inflationary within itself. Maybe this is the underlying inflation he is talking about. When you see three raises in the discount rate this close together, this is an indication that there will be more raises in the near future. The next raise will probably be March 21, 2000. Mr. Greenspan has indicated that this will be a substantial raise and not just a quarter of a point as seen before. If it is more than a quarter of a point, you may want to meet with your financial advisor and CPA.
If you are operating a business and borrowing money from a bank, see your banker now as a precaution. Solidify your loans for at least the next 18 months and try to tie down the interest rate. If the present trend of rising interest rates continues, we could be looking at a recession by next November.
The reason any of this means anything to you other than talk at the dinner table is you may want to look at your stock portfolio and what you are going to buy in the near future. If you thought about buying an expensive boat, a new car or buying a new house, time could be of the essence. Set up your loan now and see how long that rate can be held until it expires. For example, get a car loan that can be held for 60 days. You certainly don’t have to use it. A little time spent now could prove to be a little waste of time. A little time spent now could prove to be a huge savings in the very near future.
Oh wait, could this be “the wealth effect” and we are causing inflation?