During times of credit crisis and threatened economic slowdown, reductions by the Federal Reserve in the discount rate help to stimulate economic activity by enabling commercial banks to borrow money at a favorable rate. This aids the profitability of banks and encourages loan activity, which makes money more widely available to the economy and stimulates economic activity. The Fed does not necessarily reduce the discount rate all at once; rather, cuts may come in stages as economic data roll in. If the data are ominous and the Fed is particularly worried about deflation, recession, and/or credit crises, we can expect sizable cuts in the discount rate over time. For that reason, changes in the discount rate might be viewed as an indicator of Fed sentiment: the degree to which the Fed is worried about economic slowdown (leading to aggressive discount rate cutting) or overheating (leading to aggressive discount rate hiking).
So how worried is the current Fed, based on historical norms for discount rate cuts? I went back to 1965 (2248 weeks of data) and examined the rate of change for the discount rate over moving 26-week periods.
Interestingly, we're currently seeing a 36% drop in the discount rate over the latest 26-week period. Only one other period since 1965 has seen such aggressive discount rate cutting--and that was the 2001-2002 recession. (We saw a 45% drop in the discount rate during late 2001 and a 42% drop during early 2002).
Other periods of Fed worry and 26-week discount rate declines have been:
* Late 1991/Early 1992 - Down 28%
* Late 1982/Early 1983 - Down 26%
* August 1986 - Down 22%
* May 1975 - Down 21%
* August/September, 1980 - Down 21%
* May/June 1991 - Down 18%
* February-May 1971 - Down 17%
* May/June 1992 - Down 17%
Note that the vast majority of these time periods ended up being good times to buy stocks for longer-term positions. Interestingly, however, the extensive rate cutting by the Fed during the 2001-2002 period is now being blamed for the housing bubble and credit recklessness that ensued. Given that we are now seeing Fed worry (and discount rate cutting) of similar proportions, we can only speculate as to the bubbles that could arise from the latest rate actions.