Federal Reserve Discount Rate

Impact and How It Works

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The Federal Reserve Building in New York. Photo: Spencer Platt/Getty Images

Definition: The Federal Reserve discount rate is is how much the U.S. central bank charges its member banks to borrow from its discount window to maintain the reserve it requires. The Fed Board of Governors raised the rate to 1.5 percent, effective March 16, 2017.

There are three discount rates:

  1. The primary credit rate is the basic interest rate charged to most banks. It's higher than the Fed funds rate. Here's the current discount rate.
  1. The secondary credit rate is a higher rate that's charged to banks that don't meet the requirements needed to achieve the primary rate. It's typically a half a point higher than the primary rate. Here's more on the primary and secondary programs.
  2. The seasonal 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. Here's more on the seasonal discount rate program.

Why would banks need to borrow at the Fed's discount window? The Federal Reserve requires them to have a certain amount of cash on hand 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 back up 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 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  is the Fed's operations manager. This committee meets eight times a year. The members vote to change the Fed funds rate when the central bank wants 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.

For example, a higher discount rate means it's more expensive for them to borrow funds, and so they have less cash to lend out. Even if they don't borrow at the Fed discount window, they find that all the other banks have raised their lending rates as well. The Fed raises the discount rate when it wants all interest rates to rise. That's called contractionary monetary policy, and central banks use it to fight inflation. This 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. The lowers the discount rate, which means banks have to lower their interest rates to compete. This increases 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. This is 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.  

Discount Rate vs Federal Funds Rate

The discount rate is usually a percentage point above the fed funds rate, because the Fed prefers banks to borrow from each other. It's usually changed by the Federal Reserve Board of Governors in conjunction 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 these other interest rates:

  • The interest rate banks charge each other for one-month, three-month, six-month and one-year loans. This is known as LIBOR, and it affects credit card and adjustable-rate mortgage rates.
  • The rate banks charge their best customers, known as the prime rate. This then 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