Discount Rate and the Federal Reserve: Understand the Difference

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The discount rate is a tool the Federal Reserve uses to influence monetary policy. It is similar to the federal funds rate; this is the benchmark “interest rate” often referred to in discussions of federal rate policy. But there are a few key differences.

Banks are subject to reserve requirements. This means they must maintain adequate deposits to meet potential withdrawals. At the end of each night, some banks fall below this requirement; others have surplus funds. Banks that need to boost their funds overnight often borrow from other banks at the federal funds rate.

Financial institutions also have other means of borrowing. One of these methods is to borrow directly from the Fed via the “discount window.” The rate at which the Fed lends to banks via this method is known as the “discount rate.”

Learn more about the discount rate and federal funds rate.

Key Takeaways

  • Banks and other financial institutions borrow from each other at the federal funds rate; they borrow from the Fed at the discount rate.
  • The Fed qualifies loans to financial institutions as either primary credit, secondary credit, or seasonal credit. These are listed in order of stability.
  • The discount window is a tool used to protect banks from failure. It also helps them maintain liquidity levels.
  • The FOMC lowers interest rates to fuel economic growth; it raises rates to slow growth and curb inflation.

How Does the Discount Rate Work?

The Fed can adjust the discount rate independently from the federal funds rate. The discount rate is most often higher than the federal funds rate. It is used as a last resort by banks that need to borrow.

For instance, in early 2012, the primary discount rate was 0.75%. At the same time, the federal 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. The Fed banks can opt not to extend a discount window loan.

What Are the Three Types of Credit?

Since 2003, there have been three types of credit that depository 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 often higher than primary credit; seasonal credit tends to be lower. 

Underlying all three credit types is the Fed's intention to maintain adequate depository institution liquidity. They also work to keep weaker institutions out of trouble. The soundest institutions receive the "primary credit" interest rate; those that are less stable but viable receive the "secondary credit" rate. And this is also true of those with "severe financial difficulties." 

The seasonal interest rate is extended to smaller institutions serving regional markets with time-dependent needs. These could be banks serving an agricultural or resort community with widely varying seasonal financial needs. The chart below illustrates both the discount rate and federal funds rate from 2000 to 2019.

What Is the Broad Purpose of the “Discount Window”?

The discount window is further discussed in a 2002 white paper. It proposes that the discount window has two purposes. These are:

  • To make funds available at times when open market reserves are insufficient to meet surges in demand.
  • 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 (FOMC) seeks to influence interest rates. This is done in order to achieve its “dual mandate” of maximizing employment and minimizing inflation.

Note

The FOMC is the committee within the Fed that determines interest rate policy.

When the FOMC wants to support economic growth, it sets its target rate low. The lower the cost of money, in theory, the more likely people and businesses will borrow to fuel projects. For instance, the construction of a commercial property can in turn put people to work.

When the Fed wants to curb inflation, it can do the opposite: raise interest rates in order to slow growth.

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