Definition and Examples of the Federal Discount Rate
Banks borrow from each other to meet financial needs that come up throughout a business day. Since they are always moving money between accounts, creating loans, and conducting other transactions, they must keep a specific amount of reserve money on hand to meet customer withdrawals. Therefore, it is possible that a bank might come up short during the day and need some extra funding. Banks are required to keep a reserve, and if they come up short, they’ll need to borrow the money from somewhere. This is why the Federal Reserve has a facility from which banks can take out short-term loans. This facility is called the discount window. The rate at which banks are charged interest on their loans is the bank rate or discount rate. The Federal Reserve sets this rate, and banks generally set their prime lending rate based on the discount rate. The Federal Open Market Committee (FOMC) meets eight times per year to adjust the discount rate. The discount rate is also used for monetary policy to help control inflation and adjust the economy. Since March 2020, the FOMC has kept the discount rate at .25% to encourage lending and borrowing during (and following) the economic downturn caused by the coronavirus. This is the lowest discount rate in the history of the FOMC; it is likely to continue to be renewed or slightly adjusted up until the Committee sees its goal of an average of 2% inflation over the coming years.
Why Do Banks Need a Reserve?
The Federal Reserve requires banks to keep 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?
A small part of the reason is that it helps banks maintain solvency (the ability to pay off debts). The Fed makes banks keep reserves to control the amount of money, credit, and other forms of capital that they can lend out. A high reserve requirement means the bank has less money to lend. This is especially hard on small banks (less than $12.4 million in deposits), so they are exempted from the keeping reserves. This also means they don’t need to use the discount window.
How the Federal Discount Rate 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 discount and federal funds rates, which the central bank uses to encourage other banks to lend more or less. The Fed’s Board of Governors usually changes the discount rate to remain aligned with the federal funds rate. The discount rate is usually a percentage point above the federal funds rate. The Fed does this on purpose to encourage banks to borrow from each other instead of from the discount window. The Fed’s committee usually changes the rate in tandem with the changes in the federal funds rate. The Fed raises the discount rate when it wants other interest rates to rise. This is called contractionary monetary policy, and central banks use it to reduce inflation. This policy also reduces the money supply and slows lending, which slows (contracts) economic growth. The opposite of contractionary policy is expansionary monetary policy, and central banks use it to stimulate growth. The Fed policy lowers the discount rate, which means banks have to lower their interest rates to compete for loans. As a result, expansionary policies increase the money supply, spur lending, and boost (expand) economic growth—which also increases inflation.
Other Tools That Assist With Rates
The Fed has a wealth of other tools to expand or contract bank lending. In fact, its open market operations are very powerful tools that are not as well known as the discount rate or federal funds rate. The Fed conducts open market operations when they buy securities from banks to make rates fall and sells them when it wants rates to rise. To buy securities, it removes them from the banks’ balance sheets and replaces them with credit that creates out of thin air. Since this gives the bank more money to lend, banks can charge less interest. The chart below illustrates the discount rate data, ranging from 2000 to the current rate.
How the Discount Rate Affects the Economy
The discount rate affects all of these 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 is the prime rate, which affects all other interest rates Savings account and money market interest rates
The discount rate only indirectly influences fixed-rate mortgages and loans. They are mostly affected by the yields on longer-term Treasury notes.
Types of Federal Discount Rates
The FOMC sets three discount rates:
The primary credit rate, the basic interest rate charged to most banks, is generally higher than the federal funds rate The secondary credit rate is higher—charged to banks that don’t meet the primary rate requirements; it’s typically 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; local needs might include loans for farmers, students, resorts, and other borrowing activities.
