The Federal Reserve has started to normalize it’s banking policy by raising the discount rate last week, increasing the rate at which it charges banks for overnight lending. The Fed shrank the spread between the discount rate and federal funds rate early on in the liquidity crisis in 2007 and will probably return to the traditional spread sometime this year as they begin withdrawing their unprecedented stimulus to the banking system.

That being said, banks are still being fairly tight with their lending and while their capital levels have recovered somewhat, they are still in store for more losses with the labor and housing markets in their current states. Foreclosures are still on the rise and with employment opportunities scarce, that trend will likely continue for some time.

While the economy is expected to grow this year by around 3%, the free flow of credit is lagging noticeably behind in the recovery. As long as inflation remains muted the Fed would like to keep the federal funds rate near zero for some time.

Banks have recovered to the point where the Fed would prefer them to borrow from each other rather than using their discount window function as lender of last resort. Another factor that banks are carefully watching is how Congress will revamp banking regulation and how it will impact them in the long run. Read the rest of this entry »