Discount Rate Change Unimportant For Preferred Stock Investors

You may have read about the February 18 increase in the Federal Reserve’s discount rate. As far as preferred stock investors are concerned, that move makes no difference to us. This is the interest rate that banks are charged for short-term Fed loans. The reason that the February 18 increase does not affect preferred stock investors is that banks have so much reserve cash that they are not actually using the Fed’s “discount window” to borrow money these days. So increasing the discount rate matters very little.

To the extent that banks are borrowing from the Fed, they have been using a different facility called the Term Auction Facility. That program is scheduled to end in March. To discourage banks from going to the discount window for short-term loans, the discount rate was bumped up while the federal funds rate remains unchanged at near-zero.

By discontinuing the Term Auction Facility, increasing the discount rate and leaving the federal funds rate unchanged at near-zero, the Fed has created an environment where banks will get these short-term loans from each other, rather than from the Fed so no new money is injected into the system.

This approach eases the inflationary pressure that injecting new cash would otherwise create.

In this complex maneuver, the Fed is able to reduce inflationary pressure without increasing the cost of money throughout the economy (which would be deadly for many businesses at this point).

It is the federal funds rate that will have an impact on preferred stock investors since it is this rate that directly influences the interest rates offered by corporate bonds and new preferred stock issues.

As long as the Fed holds off increasing the federal funds rate, the crisis-caused excess yield within the preferred stock market will continue to be eliminated (i.e. market prices should continue to increase; by how much? see related article from the February issue of the CDx3 Newsletter). It is the federal funds rate that preferred stock investors should pay attention to much more so than the discount rate.

Many Happy Returns.