Federal Discount Rate

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What Is The Federal Discount Rate?

The federal discount rate is the rate of interest at which financial institutions that meet certain eligibility criteria can borrow funds from the Federal Reserve (the central bank of the United States). It is one of the tools used by the Federal Reserve to control monetary policy and influence the overall economic conditions in the country.

The discount rate serves as a means for these financial institutions to obtain liquidity for a short-term duration from the Federal Reserve. During times of financial stress or temporary cash shortages, banks can borrow money from the central bank to meet their reserve requirements and maintain stability in the banking system.

What Is The Federal Discount Rate?

The federal discount rate refers to the interest rate at which certain depository institutions (typically commercial banks) can borrow money directly from the Federal Reserve's discount window.
The discount rate is one of the instruments the Federal Reserve uses to make changes in monetary policy. It thus helps them to manage the overall economy.
The Federal Reserve more directly controls the discount rate, while the supply and demand dynamics of the interbank lending market determine the federal funds rate.

Federal Discount Rate Explained

Federal Discount Rate is the rate of interest at which depository institutions that meet certain eligibility criteria can borrow money directly from the Federal Reserve. It operates as a tool used by the Federal Reserve to manage monetary policy and provide liquidity support to eligible depository institutions.

The rate is set by the Federal Reserve's Board of Governors. It serves as the interest rate at which these institutions can borrow directly from the central bank. When a bank faces temporary cash shortages or increased liquidity needs, it can turn to the discount window for short-term borrowing. However, borrowing from the discount window is typically seen as a last resort. This is because healthy banks are expected to seek funding from other sources first.

The discount rate has different tiers: the primary credit rate for financially sound institutions, the secondary credit rate for those with higher risk, and the seasonal credit rate for smaller institutions in specific communities. Collateral is a requirement to secure the loan, and repayment terms are generally short-term. Changes in the discount rate can influence borrowing costs and signal the Federal Reserve's stance on monetary policy. By providing this facility, the discount rate helps ensure stability in the banking system. It also supports the overall functioning of the economy.

Types

There are three main types of federal discount rates:

Primary Credit Rate: It is the most common discount rate. It is typically above the target range for the federal funds rate. This is the rate at which banks lend reserves to each other on an overnight basis. The primary credit rate is offered to financially healthy banks. It serves as a source of funding for their short-term needs of liquidity. Banks should exhaust other funding options before turning to the primary credit rate.
Secondary Credit Rate: The secondary credit rate is higher than the primary credit rate. It is offered to institutions that do not meet the requirements for primary credit. This rate reflects a higher level of risk associated with borrowing from the Federal Reserve. The purpose of the secondary credit rate is to discourage institutions from relying too heavily on the discount window. It also encourages them to address any financial weaknesses.
Seasonal Credit Rate: The seasonal credit rate is available to smaller depository institutions located in seasonal or agricultural communities that experience predictable fluctuations in their funding needs. These institutions may face temporary liquidity challenges during specific times of the year due to seasonal factors. The seasonal credit rate is typically lower than the primary and secondary credit rates and helps ensure that these institutions have access to funds to meet their funding requirements during peak periods.

Examples

Let us look at the federal discount rate examples to understand the concept better -

Example #1

Let's say the Federal Reserve sets the federal discount rate at 3% for primary credit. This means that financially healthy banks or depository institutions can borrow money directly from the Federal Reserve at an annual interest rate of 3%.

For instance, Bank ABC finds itself facing a temporary shortage of funds due to unforeseen circumstances. Despite its best efforts to secure funding from other sources, it is unable to obtain the necessary liquidity. In this situation, Bank ABC can turn to the Federal Reserve's discount window and borrow funds at the federal discount rate of 3%.

By borrowing from the discount window, Bank ABC can address its immediate liquidity needs and ensure it meets its reserve requirements. The borrowed funds can be used to cover any temporary shortfall in available cash and maintain the stability and smooth functioning of the bank's operations.

Example #2

Following its June 13-14, 2023 meeting, the Federal Reserve has decided to keep interest rates unchanged, maintaining the federal funds rate within a target range of 5.0% to 5.25%. This decision marks a departure from the previous pattern of rate increases observed over the past ten consecutive meetings. The intention behind this move is to stabilize liquidity in the financial markets and mitigate the risk of elevated inflation.

In response to inflation easing to 4% year-over-year in May 2023 from its peak of over 9% in mid-2022, the Federal Reserve has chosen to maintain the current interest rates. However, future projections indicate that the possibility of further rate hikes remains on the table before the year concludes, contingent upon the prevailing conditions.

Federal Discount Rate vs Federal Funds Rate

The differences between the federal discount rate and the federal fund rate are as follows –

Basis	Federal Discount Rate	Federal fund Rate
Meaning	The interest rate at which depository institutions that meet certain eligibility criteria can borrow funds directly from the Federal Reserve.	The rate of interest at which depository institutions can borrow or lends money from each other on an overnight basis in the federal funds market.
Availability	Available only to depository institutions that meet eligibility criteria through the Federal Reserve's discount window.	Accessed by depository institutions in the interbank market, where they lend or borrow funds from each other.
Duration	Typically used for short-term borrowing, including overnight loans, but can be extended in exceptional circumstances.	Applies to overnight lending transactions in the interbank market.

Frequently Asked Questions (FAQs)

1. When the Federal reserve board raises the federal discount rate?

The Federal Reserve Board raises the discount rate when it wants to tighten monetary policy and curb inflationary pressures in the economy. The specific timing and frequency of discount rate changes are determined by the Federal Reserve based on its assessment of economic conditions and its monetary policy objectives.

2. What is the federal discount rate history?

The federal discount rate has a history that dates back to the establishment of the Federal Reserve in 1913. Initially set at 4%, the discount rate served as a tool to provide liquidity to banks during times of financial stress. During the Great Depression in the 1930s, the rate was lowered to its lowest point of 0.50% to support economic recovery. In the late 1970s and early 1980s, the rate reached its peak at 13.0% as part of efforts to combat high inflation. In recent years, the discount rate has generally followed a downward trend, being adjusted periodically based on economic conditions and monetary policy objectives.

3. Why is the discount rate higher than the federal funds rate?

The discount rate serves as a tool for the Federal Reserve to provide loans to depository institutions as a lender of last resort during times of financial stress. By setting the discount rate higher than the federal funds rate, the Federal Reserve encourages banks to first seek funds from the interbank market (federal funds market) before resorting to borrowing from the central bank.