Discount Rate and the Federal Reserve
The discount rate is one of the tools the Federal Reserve uses to influence monetary policy. While it is similar to the federal funds rate – the benchmark “interest rate” often referred to in discussions of Fed rate policy – there are a few key differences.
Banks are subject to reserve requirements -- adequate deposits to meet potential withdrawals. At the end of each night, some banks fall below this requirement, while others have surplus funds. Banks that need to boost their funds overnight typically borrow from other banks at the fed funds rate.
Financial institutions also have other means of borrowing, one of which is to borrow directly from the Federal Reserve via the “discount window.” The rate at which the Fed lends to banks via this facility is known as the “discount rate.”
Details of the Discount Rate
The Fed can adjust the discount rate independently from the fed funds rate. The discount rate is typically higher than the fed funds rate, so it is used as a last resort by banks that need to borrow. For example, in early 2012 the primary discount rate was 0.75%, while the fed funds rate was targeted in a range from 0% to 0.25%. Bank borrowers also need to put up collateral to borrow from the discount window, and the Federal Reserve banks can opt not to extend a discount window loan.
Since January 2003, there have been three types of credit that depositary institutions can acquire at the Fed’s discount window: primary credit, secondary credit, and seasonal credit. Each has its own interest rate. Secondary credit is typically higher than primary credit, while seasonal credit tends to be lower.
Underlying all three credit types is the Federal Reserve's intention to maintain adequate depository institution liquidity and to keep weaker institutions out of trouble. The soundest institutions receive the "primary credit" interest rate; less-stable but viable institutions receive the "secondary credit" rate, as do institutions with "severe financial difficulties." The seasonal interest rate, as the name implies, is extended to smaller institutions serving regional markets with time-dependent needs, such as banks serving an agricultural community or a resort community with widely varying seasonal financial needs.
Broad Purpose of the “Discount Window”
The discount window is further discussed in a 2002 Federal Reserve white paper, which proposes that its purpose is:
- To make funds available at times when open market reserves are insufficient to meet surges in demand, and
- To help "financially sound" depository institutions avoid account overdrafts or related reserve requirement shortfalls.
Why Does the Fed Adjust the Discount Rate?
As is the case with the federal funds rate, the Federal Open Market Committee – the committee within the Federal Reserve that determines interest rate policy – seeks to influence interest rates in order to achieve its “dual mandate” of maximizing employment and minimizing inflation. When the committee wants to support economic growth, it sets its target rate low. The lower the cost of money, in theory, the more likely individuals and businesses will borrow to fuel projects – like the construction of a commercial property, which in turn puts people to work.
When the Fed wants to curb inflation, it can do the opposite: raise interest rates in order to slow growth.