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What is the 'Federal Discount Rate'

The federal discount rate is the interest rate set by central banks - in the U.S. by the Federal Reserve - on loans extended by the central bank and offered to eligible commercial banks or other depository institutions as a measure to reduce liquidity problems and the pressures of reserve requirements. The discount rate allows central banks such as the Federal Reserve to control the supply of money and is used to assure stability in the financial markets.

Borrowing from the central bank is a substitute for borrowing from other commercial banks, and so it is discouraged as a last-resort measure once the interbank overnight lending system has been maxed out. The Federal Reserve sets this interbank rate, called the Fed funds rate, which is usually set lower than the discount rate. Both the Fed funds and discount rates adjust to balance the supply of, and demand for, currency 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. As long as the Fed funds rate is lower than the discount rate, commercial banks will prefer to borrow from another commercial bank rather than the Fed.

BREAKING DOWN 'Federal Discount Rate'

Over the course of each day, as banks pay out and receive funds, they may end up with more (or fewer) funds than they need to meet their reserve requirement target. Banks with excess funds typically lend them overnight to other banks that are short on funds, rather than leaving those funds in their non-interest-bearing reserve accounts at the Fed or as idle vault cash.

Depository institutions and commercials banks that are in generally sound financial condition are eligible to borrow from their regional Federal Reserve banks at a primary credit, or discount, rate. These loans are normally extended on an overnight basis so that banks can meet short-term liquidity needs. Funds for commercial banks borrowed from the Fed to improve their money supply are processed through the discount window, and the rate is reviewed every 14 days. The federal discount rate is one of the most important indicators in the economy, as most other interest rates move up and down with it.

Healthy banks are allowed to borrow all they want at very short maturities (usually overnight) from the Fed's discount window, and it is therefore referred to as a standing lending facility. The interest rate on these primary credit loans is the discount rate itself, which is typically set higher than the federal funds rate target, usually by 100 basis points (1 percentage point), because the central bank prefers that banks borrow from each other so that they continually monitor each other for credit risk and liquidity. As a result, in most circumstances the amount of discount lending under the primary credit facility is very small, intended only to be a backup source of liquidity for sound banks so that the federal funds rate never rises too far above its target – it theoretically puts a ceiling on the Fed funds rate to equal the discount rate.

Secondary credit is given to banks that are in financial trouble and are experiencing severe liquidity problems. The central bank's interest rate on secondary credit is set at 50 basis points (0.5 percentage points) above the discount rate. The interest rate on these loans is set at a higher penalty rate to reflect the less-sound condition of these borrowers.

Under normal circumstances, the discount rate sits in between the Fed Funds rate and the secondary credit rate. Example: Fed funds rate = 1%; discount rate = 2%, secondary rate = 2.5%.

Federal Reserve Monetary Tools

The federal discount rate is used as a tool to either stimulate (expansionary monetary policy) or rein in (contractionary monetary policy) the economy. A decrease in the discount rate makes it cheaper for commercial banks to borrow money, which results in an increase in available credit and lending activity throughout the economy. Conversely, a raised discount rate makes it more expensive for banks to borrow and thereby diminishes the money supply while retracting investment activity.

Besides setting the discount rate, the Federal Reserve can influence money supply, credit and interest rates through open market operations (OMO) in U.S. Treasury markets, and by raising or lowering reserve requirements for private banks. The reserve requirement is the portion of a bank's deposits that it must hold in cash form, either within its own vaults or on deposit at its regional Federal Reserve bank. The higher the reserve requirements are, the less room banks have to leverage their liabilities, or deposits. Higher reserve requirements are more typical during a recession when a central bank wants to ensure banking panics and runs don't cause financial failures. The Federal Reserve acts upon its dual mandate to maximize employment and reduce inflation.

The discount rate is determined by the Federal Reserve's board of governors, as opposed to the federal funds rate, which is set by the Federal Open Markets Committee (FOMC). The FOMC sets the Fed funds rate through the open sale and purchase of U.S. Treasuries, whereas the discount rate is reached solely through review by the board of governors.

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