What is the federal interest rate?

The Fed’s discount rate is the interest rate on central bank loans to commercial banks and other depository institutions. Central banks like the Fed may influence money supply, liquidity, reserve requirements, and financial market stability by adjusting the discount rate.

This differs from the federal funds rate, the overnight interbank lending rate for commercial banks to borrow and lend surplus reserves. The Fed sets the objective, but overnight loan supply and demand determine the Fed funds rate.

Banks that cannot borrow in the interbank market should employ the discount rate, which is higher than the fed funds rate, as a last option. For Fed loans to liquidity-strapped banks, the secondary discount rate is considerably greater.

How Federal Discount Rate Works

Fed banks can lend directly to member banks and depository institutions in addition to other monetary policy and regulatory measures. The Fed’s primary goal as a lender of last resort is to stabilize banks and the financial system. As a standing lending facility, healthy banks can borrow whatever they desire at very short maturities (typically overnight) from the Fed’s discount window to prevent bank collapses.

Banks typically borrow overnight. However, banks with higher liquidity needs or risks may be unable to raise funds in the open market. Fed discount lending provides liquidity to banks that are about to fail once the interbank overnight lending system is complete.

Central bank borrowing is a last resort since it replaces commercial bank borrowing. Fed funds, the interbank rate, is frequently lower than the discount rate. Commercial banks prefer to borrow from each other over the Fed if the Fed funds rate is lower than the discount rate. Thus, discount lending is usually limited and meant solely as a liquidity backstop for solid institutions.

Triple Discounted Rates

Discount financing is usually primary or secondary. Banks serving agricultural and other seasonal credit needs get a seasonal discount rate for non-emergency lending from the Fed.

Depository institutions and commercial banks in good financial shape can borrow from regional Fed banks at a primary credit rate. UI usually calls the discount rate. The discount window processes Fed loan dollars for commercial banks and the pace is revised every 14 days.

Financially troubled institutions with serious liquidity issues receive secondary loans. Secondary credit interest rates are usually 0 basis points (0.5 percentage points) over the discount rate by the central bank. These loans have a higher penalty rate since the borrowers are less stable.

Monetary Policy and Discount Rate

In addition to preventing bank collapses, the federal discount rate stimulates or slows the economy.

A lower discount rate makes commercial banks’ borrowing costs cheaper, increasing credit and lending activity in the economy. Conversely, a higher discount rate raises bank borrowing costs, reducing money supply and investment.

In addition to establishing the discount rate, the Fed has other monetary policy instruments. Open market operations (OMO) in U.S. Treasury markets and private bank reserve requirements can affect money supply, lending, and interest rates.

The reserve requirement is the portion of a bank’s deposits in cash, either in its vaults or at its regional Fed bank. As reserve requirements rise, banks cannot leverage liabilities or warranties.

Fed Discount vs. Fed Funds

The federal discount rate is the Fed lending interest rate. This differs from the federal funds rate, at which banks charge each other for loans to meet reserve requirements.

Unlike the federal funds rate, which member banks establish, the Fed’s board of governors sets the discount rate. The FOMC targets the Fed funds rate by openly selling and buying U.S. Treasury bonds while the board of governors reviews the discount rate.

The central bank likes banks to borrow from one another to manage credit risk and liquidity. Hence, the discount rate is usually 100 basis points (1 percentage point) higher than the federal funds rate goal.

Why is the discount rate higher than the Fed Funds target?

The discount rate is greater than the goal of the federal funds rate to provide banks with liquidity if they cannot receive financing from other banks. The Fed prefers banks borrow and lend instead of using the discount window and raises the discount rate to discourage its usage until required.

Why does the Fed change the discount rate?

The Federal Reserve adjusts the discount rate and federal funds rate targets to boost or slow economic activity. When the economy grows too fast and inflation rises, the Fed may raise rates to discourage lending and borrowing and lower inflation. When the economy is sluggish or in recession, the Fed may decrease interest rates to boost growth and recovery.

Which matters more? Fed Funds Rate or Discount Rate?

For economic impact, the federal funds rate is typically more essential. Many interest rates, including mortgages, personal loans, bonds, and derivatives, depend on the Fed funds rate.

Less often employed, the discount rate has less influence on economic lending and borrowing.

In Summary

Commercial banks and other financial institutions borrow and lend overnight reserve cash at the federal funds rate. The Fed sets the goal, but the interbank market determines the rate. Open market operations (OMO) like purchasing or selling government securities may help the Federal Reserve keep the fed funds rate around its goal.

However, banks can borrow money directly from the Federal Reserve’s discount window at the discount rate. This rate will be higher than the fed funds rate to support banks that cannot get enough interbank money.

Conclusion

• Banks borrow cash from Federal Reserve banks from the discount window at the federal discount rate.
• The Fed’s Board of Governors sets the discount rate, which can be changed for monetary policy.
• As a lender of last resort, the Fed uses the discount rate as a monetary policy instrument.
• The Fed sets the objective of the federal funds rate, but the interbank money market supply and demand for overnight loans decide the pace.