The central bank for the United States—the Federal Reserve (the Fed)—is tasked with maintaining a certain level of stability within the country's financial system. Specific tools are afforded the Fed that allow for changes to broad monetary policies intended to implement the government's planned fiscal policy. These include the management and oversight of the production and distribution of the nation's currency, sharing of information and statistics with the public, and the promotion of economic and employment growth through the implementation of changes to the discount rate.

The most influential economics tool the central bank has under its control is the ability to increase or decrease the discount rate. Shifts in this crucial interest rate have a drastic effect on the building blocks of macroeconomics, such as consumer spending and borrowing.

Key Takeaways

  • The Fed sets target interest rates at which banks lend to each other overnight in order to maintain reserve requirements - this is known as the fed funds rate.
  • The Fed also sets the discount rate, the interest rate at which banks can borrow directly from the central bank, at a level 1% greater than the target fed funds rate.
  • If the Fed raises interest rates, it increases the cost of borrowing, making both credit and investment more expensive. This can be done to slow an overheated economy.
  • If the Fed lowers rates, it makes borrowing cheaper which encourages spending on credit and investment. This can be done to help stimulate a sagging economy.

Overnight Lending and Bank Reserves

Banks are required by the Fed to have a minimum amount of reserves on hand, which is currently set at 10%. This means that a bank with $1 million on deposit must maintain at least $100,000 on reserve and is free to lend out the remaining $900,000 to borrowers or other banks. Each day, bank reserves are depleted or augmented as customers carry out day-to-day banking and make payments, withdrawals and deposit.

At the end of the business day, if more withdrawals have been made than deposits, the bank may find itself with too little reserves, say just $50,000 left, and will be below regulatory requirements. It will then have to borrow the other $50,000 overnight as a short-term loan.

If another bank sees more deposits than outflows, it may find itself with perhaps $150,000 available, and so can lend $50,000 to the first bank. It would prefer to lend those excess reserves and earn a small amount of income on it rather than have it sit idly as cash earning zero yield. The rate at which banks lend to each other overnight is called the federal funds rate (or fed funds rate for short), and is set by the supply and demand in the market for such short-term reserves loans.

If there are no banks with reserves willing to lend to those in need, that bank can instead borrow directly from the fed, at a rate known as the discount rate.

The Fed Funds Rate and Discount Rate

For banks and depositories, the discount rate is the interest rate assessed on short-term loans acquired from regional central banks. In other words, the discount rate is the interest rate at which banks can borrow from the Fed directly.

Financing received through federal lending is most commonly used to shore up short-term liquidity needs for the borrowing financial institution; as such, loans are extended only for an overnight term. The discount rate can be interpreted as the cost of borrowing from the Fed.

Remember, the interest rate on the inter-bank overnight borrowing of reserves is called the "fed funds rate." It adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the fed funds market is greater than the demand, then the funds rate falls, and if the supply of reserves is less than the demand, the funds rate rises. The fed sets a target interest rate for the fed funds rate, but that actual rate will vary with the supply and demand for overnight reserves. The Fed also sets the discount rate at a level 1% higher than the fed funds rate target. So if the target rate on the fed funds is 1%, the discount rate would be 2%.

The discount rate is set higher than the federal funds rate target because the fed prefers that banks borrow from each other in the so that they continually monitor each other for credit risk. As a result, in most circumstances the amount of discount lending under the discount window facility is very small. Instead, it is intended to be a backup source of liquidity for sound banks so that the federal funds rate never rises too far above its target—it puts a ceiling on the fed funds rate.

Decreasing Interest Rates

When the Fed makes a change to either the fed funds rate or the discount rate, economic activity either increases or decreases depending on the intended outcome of the change. When the nation's economy is stagnant or slow, the Federal Reserve may enact its power to reduce the discount rate in an effort to make borrowing more affordable for member banks.

When banks can borrow funds from the Fed at a less expensive rate, they are able to pass the savings to banking customers through lower interest rates charged on personal, auto, or mortgage loans. This creates an economic environment that encourages consumer borrowing and ultimately leads to an increase in consumer spending while rates are low.

Although a reduction in the discount rate positively affects interest rates for consumers wishing to borrow from banks, consumers experience a reduction to interest rates on savings vehicles as well. This may discourage long-term savings in safe investment options such as certificates of deposit (CDs) or money market savings accounts.

Increasing Interest Rates

When the economy is growing at a rate that may lead to hyperinflation, the Fed may increase interest rates. When member banks cannot borrow from the central bank at an interest rate that is cost-effective, lending to the consuming public may be tightened until interest rates are reduced again. An increase to the discount rate has a direct impact on the interest rate charged to consumers for lending products, and consumer spending shrinks when this tactic is implemented.

Although lending is not as attractive to banks or consumers when the discount rate is increased, consumers are more likely to receive more attractive interest rates on low-risk savings vehicles when this strategy is set in motion.

The Bottom Line

The Fed, like all central banks, uses interest rates to manage the macro-economy. Raising rates makes borrowing more expensive and slows down economic growth, while cutting rates encourages borrowing and investment on cheaper credit. All of this ripples out from the overnight lending rate that banks must utilize in order to maintain their required reserves of cash—which is also set by the Fed.