The news yesterday that the U.S. Federal Reserve raised the discount rate 25 basis points (to 0.75 percent from 0.50 percent) is being interpreted as an indication of a fundamental change in how the Fed views our economic crisis. The hike in the discount rate could signal the beginning of the end of our economic crisis.

The discount rate is not to be confused with the more prominent Fed funds rate. The Fed funds rate is the rate at which banks lend money to each other in overnight loans for regulatory and liquidity requirements. The discount rate is the rate at which the Fed lends money to private retail banks — traditionally at a percent above the Fed funds rate — in short-term loans aimed at easing liquidity constraints. But in recent decades borrowing from the so-called discount window had been seen by large banks as the financial equivalent of pulling over to ask for directions — you can do it, but it’s seen as a sign of weakness. The aftermath of 9/11 was the last time the discount window had seen serious activity prior to the 2008 economic crisis.

The Fed met the current crisis in part by making the discount window more available to banks. The terms of loans through the discount window went from being overnight to ultimately 90 days. The discount rate was cut from being 100 basis points (one percent) above the Fed funds rate to 50 basis points. And in a move that underscored the gravity of the October 2008 liquidity crisis, Goldman Sachs and Morgan Stanley turned themselves into bank holding companies — a technical change in their operating structure that required much more oversight — in part to be able to access the discount window in case they faced a liquidity crunch.

This opening of the discount window was part of a larger project by the Fed — which involved pumping liquidity into the economy by buying up almost two trillion dollars in assets — to prevent the crisis of fall 2008 from leading to a global depression. But now that the worst seems to be over from a monetary perspective, the Fed is beginning to step away from the crash position it assumed almost two years ago.

Newly reappointed Fed Chairman Ben Bernanke laid out a plan for unwinding the Fed’s position in the economy last week, testifying to Congress that “when the times comes,” the Fed will move to sell that two trillion in assets (in an orderly fashion) to a stronger market. This would give the Fed more room to manage the economy to bring us out of recession. The raising of the discount rate would be the first step in that process.

The phrase “when the time comes,” however, makes all the difference in the world, and many wiser people than I are expecting the Fed to go easy on its plan to shrink it’s balance sheet and raise rates. With unemployment hovering at 10 percent, this recession isn’t over for a lot of Americans. And, despite last quarter’s strong headline number, there is no obvious driver of GDP growth (like exports) on the horizon, so it may not be over for the rest of us, either. So it may be too soon to call the recession over and begin raising rates. The fear is that this may not be the beginning of the end, but the end of the beginning.

Photo credit: http://www.flickr.com/photos/laurapadgett/ / CC BY-ND 2.0