Federal discount rate

What Is the Federal Discount Rate?

The Federal Discount Rate is the interest rate at which eligible commercial banks and other depository institutions can borrow money directly from the Federal Reserve (Fed) through its "discount window." This rate is a key component of monetary policy and falls under the broader financial category of central banking. The discount rate serves as a backstop source of liquidity, helping financial institutions manage temporary funding shortfalls and maintain stability within the banking system⁴⁸, ⁴⁹. The Federal Reserve uses the discount rate as one of its tools to influence the money supply, credit conditions, and overall interest rates in the economy⁴⁷.

History and Origin

The concept of central bank lending to commercial banks has been a cornerstone of central banking since its inception. When the Federal Reserve System was established in 1913, lending reserve funds through the discount window was initially intended to be the principal instrument of central banking operations⁴⁶. This mechanism allowed the Fed to provide liquidity to banks that faced temporary shortages, thereby preventing broader financial panics.

Over time, while the discount window's role in providing liquidity remains crucial, its prominence as a primary monetary policy tool shifted. By the mid-22nd century, open market operations largely supplanted the discount window in its role of influencing the money supply directly⁴⁵. However, the discount rate continues to serve a complementary function by setting a ceiling on short-term interest rates and acting as an emergency source of funds⁴³, ⁴⁴. For instance, during periods of significant financial distress, such as the 2007-2008 global financial crisis, the use of the Fed's discount window soared as the central bank worked to inject liquidity into the financial system. In early 2023, the failure of several large banks again brought the discount window into the spotlight, with lending reaching an all-time high⁴².

Key Takeaways

• The Federal Discount Rate is the interest rate charged by the Federal Reserve to commercial banks borrowing from its discount window.
• It serves as a critical tool for providing liquidity to the banking system and ensuring financial stability.
• The discount rate helps manage banks' liquidity risks and influences overall credit conditions.
• There are three main types of discount window credit: primary, secondary, and seasonal, each with its own rate⁴⁰, ⁴¹.
• While an important backstop, a "stigma" has historically been associated with borrowing from the discount window, leading banks to prefer other funding sources³⁷, ³⁸, ³⁹.

Interpreting the Federal Discount Rate

The Federal Discount Rate is a direct indicator of the cost for eligible depository institutions to borrow from the Federal Reserve. Generally, the discount rate is set higher than the federal funds rate target, which is the interest rate at which commercial banks lend reserves to each other overnight. This higher rate is intended to encourage banks to seek funds from the interbank market first, with the discount window acting as a last resort.

When the Federal Reserve lowers the discount rate, it makes it cheaper for banks to borrow, which can lead to an increase in available credit and lending activity throughout the economy—an expansionary monetary policy. Conversely, raising the discount rate makes borrowing more expensive for banks, potentially diminishing the money supply and retracting investment activity—a contractionary monetary policy.

Hypothetical Example

Imagine "Diversification Bank," a commercial bank, experiences an unexpected surge in withdrawals, leading to a temporary shortfall in its reserve requirements at the end of the day. Diversification Bank first attempts to borrow funds from other banks in the interbank market. However, due to unusual market conditions, interbank lending rates are high, or willing lenders are scarce.

In this scenario, Diversification Bank can turn to the Federal Reserve's discount window to cover its shortfall. If the primary credit rate (a type of discount rate) is 5.50%, Diversification Bank can borrow the needed funds at this rate, provided it pledges acceptable collateral. Th³⁵, ³⁶is immediate access to funds prevents Diversification Bank from facing a liquidity crisis and helps it continue to meet its obligations to customers. The availability of this backstop ensures the smooth functioning of the banking system.

Practical Applications

The Federal Discount Rate has several practical applications within the financial system:

• Liquidity Management: For individual financial institutions, the discount window provides a crucial backstop for managing short-term liquidity risks. Ba³³, ³⁴nks use it to cover temporary funding shortfalls that might arise from unexpected cash flow mismatches or significant deposit outflows.
• ³² Monetary Policy Implementation: While not the primary tool, the discount rate complements other monetary policy instruments, such as open market operations. By adjusting the discount rate, the Federal Reserve can signal its stance on monetary policy and influence broader interest rates, thereby impacting economic growth and inflation.
• ³¹ Financial Stability: The availability of the discount window, at a rate set by the Fed, supports the overall stability of the financial system. It²⁹, ³⁰ assures banks that a reliable source of funds is available, even during periods of market stress, preventing isolated liquidity issues from escalating into systemic crises. Th²⁸is function is particularly vital during times of economic distress, as highlighted by its increased use during the 2023 banking turmoil.

#²⁷# Limitations and Criticisms

Despite its crucial role, the Federal Discount Rate and the discount window facility face certain limitations and criticisms, primarily concerning "stigma." The long-standing perception that borrowing from the discount window signals financial weakness can deter banks from using it, even when they genuinely need liquidity. Th²⁵, ²⁶is "stigma" can lead banks to avoid the discount window at all costs, sometimes paying higher rates in the private market rather than borrowing from the Fed.

T²⁴his reluctance undermines the discount window's effectiveness as a safety valve during times of widespread liquidity concerns. So²³me research indicates that this stigma impaired the discount window's effectiveness during past financial crises, such as the period following the October 1987 stock market crash and the August 2007 financial market strains. Th²¹, ²²e fear of being perceived as financially unstable by counterparties, regulators, and the public can discourage banks from accessing this vital liquidity source, potentially exacerbating market disruptions. Fu¹⁹, ²⁰rthermore, "anticipatory stigma" can prevent banks from making the necessary operational preparations to effectively access the discount window, further reducing its utility.

#¹⁸# Federal Discount Rate vs. Federal Funds Rate

The Federal Discount Rate and the federal funds rate are both key interest rates influenced by the Federal Reserve, but they represent different borrowing avenues for banks.

The Federal Discount Rate acts as a ceiling for short-term interbank lending rates, as banks would theoretically borrow from the Fed if the federal funds rate rose above the discount rate. Ho¹⁷wever, due to the aforementioned "stigma," banks often prefer to pay a premium in the federal funds market rather than utilize the discount window.

#¹⁶# FAQs

Who sets the Federal Discount Rate?

The board of directors of each regional Federal Reserve Bank proposes changes to the discount rate every 14 days, subject to the review and determination of the Board of Governors of the Federal Reserve System.

#¹³, ¹⁴, ¹⁵## Why is the Federal Discount Rate important?
The Federal Discount Rate is important because it provides a safety net for banks facing temporary liquidity issues, supports the overall stability of the financial system, and serves as a tool for the Federal Reserve to influence the cost of money and credit in the economy.

#¹²## What are the different types of discount window credit?
The Federal Reserve offers three main types of discount window credit:

• Primary Credit: Available to generally sound depository institutions, typically at a rate at the top of the target range for the federal funds rate.
• ¹¹ Secondary Credit: Available to institutions not eligible for primary credit, usually extended overnight at a higher rate.
• ⁹, ¹⁰ Seasonal Credit: Designed for smaller institutions that experience seasonal fluctuations in their deposits and loans, common in agricultural or tourist areas.

#⁶, ⁷, ⁸## How does the Federal Discount Rate affect consumers?
While consumers do not directly borrow at the Federal Discount Rate, changes to it can indirectly affect them. If the Federal Reserve lowers the discount rate, it can encourage banks to lend more, potentially leading to lower interest rates on loans for consumers, such as mortgages or car loans. Conversely, an increase in the discount rate could lead to higher borrowing costs for consumers.

#⁵## What is the "discount window stigma"?
The "discount window stigma" refers to the reluctance of banks to borrow from the Federal Reserve's discount window due to concerns that it might signal financial distress to market participants, regulators, and the public. Th², ³, ⁴is perception can hinder the effectiveness of the discount window as a tool for liquidity provision during times of stress.¹