Federal Reserve Discount Rate
Impact and How It Works
The Federal Reserve discount rate is the rate that the U.S. central bank charges member banks to borrow from its discount window to maintain the bank's cash reserve requirements. On March 16, 2020, the Federal Reserve Board of Governors lowered the rate to 0.25% in response to the COVID-19 coronavirus outbreak.
The Three Discount Rates
There are three discount rates:
- The primary credit rate—the basic interest rate charged to most banks—is higher than the fed funds rate and currently sits at 0.25%.
- The secondary credit rate is a higher rate—charged to banks that don't meet the primary rate requirements. It's 0.75%. It's typically a half a point higher than the primary credit rate.
- The seasonal discount rate is for small community banks that need a temporary boost in funds to meet local borrowing needs. That may include loans for farmers, students, resorts, and other seasonal activities.
Why would banks need to borrow at the Fed's discount window? The Federal Reserve requires them to have a certain amount of cash each night, known as the reserve requirement. Banks that lent out too much that day need to borrow funds overnight to meet the reserve requirement. Usually, they borrow from each other. The Fed provides the discount window as a backup in case they can't get the funds elsewhere.
Why does the Fed require a reserve? Partly to maintain solvency, but mostly to control the amount of money, credit, and other forms of capital that banks lend out. A high reserve requirement means the bank has less money to lend. Since it's especially hard on small banks (less than $12.4 million in deposits), they are exempted from the requirement. They don't have to worry about using the discount window at all.
How It Works
The Federal Open Market Committee acts as the Fed's operations manager and meets eight times a year. Committee members vote to change the fed funds rate allowing the central bank to encourage other banks to lend either more or less. The Fed's Board of Governors usually changes the discount rate to remained aligned with the fed funds rate.
A higher discount rate means it's more expensive for banks to borrow funds, so they have less cash to lend.
Even if banks don't borrow at the Fed discount window, they find that all the other banks have raised their lending rates. The Fed raises the discount rate when it wants all interest rates to rise—known as contractionary monetary policy—it is used by the central banks to fight inflation. This policy reduces the money supply, slows lending, and therefore slows economic growth.
The opposite is called expansionary monetary policy, and the central banks use it to stimulate growth. This Fed policy lowers the discount rate, which means banks have to lower their interest rates to compete. Expansionary policies increase the money supply, spurs lending, and boosts economic growth.
The Fed has a wealth of other tools to expand or constrict bank lending. In fact, its open market operations is a very powerful operation that's not as well known as the discount rate or fed funds rate. Open market operations are when the Fed buys securities from banks when it wants the rate to fall and sells them when it wants rates to rise.
To buy securities, for example, it simply removes them from the banks' balance sheets and replaces them with credit that it has simply created out of thin air. Since it gives the bank more money to lend, it's willing to lower interest rates just to put the money to work.
The chart below illustrates the discount rate data, ranging from 2000 to its projections in 2022.
Discount Rate Versus Federal Funds Rate
The discount rate is usually a percentage point above the fed funds rate. The Fed does this on purpose to encourage banks to borrow from each other instead of from it. The Fed's Board changes it in tandem with the FOMC's changes in the fed funds rate.
On August 17, 2007, the Fed board made the unusual decision to lower the discount rate without lowering the fed funds rate. It did this to restore liquidity in the overnight borrowing markets. It was trying to combat a lack of confidence banks had with each other. They were unwilling to lend to each other because none wanted to get stuck with the other's subprime mortgages.
How the Discount Rate Affects the Economy
The discount rate affects all of these other interest rates:
- The interest rate banks charge each other for one-month, three-month, six-month, and one-year loans—known as Libor, which affects credit card and adjustable-rate mortgage rates.
- The rate banks charge their best customers—known as the prime rate, which affects all other interest rates.
- Savings account and money market interest rates.
Fixed-rate mortgages and loans are only indirectly influenced by the discount rate. They are mostly affected by the yields on longer-term Treasury notes.