What Is the Federal Discount Rate?
Let me explain the federal discount rate directly: it's the interest rate the Federal Reserve sets for loans it extends to commercial banks or other depository institutions. By adjusting this rate, central banks like the Fed address liquidity issues, ease reserve requirement pressures, control the money supply, and maintain stability in financial markets.
Don't confuse this with the federal funds rate, which is the target rate for overnight lending between banks where they borrow and lend excess reserves. The Fed sets the target, but the actual rate comes from market supply and demand for those loans.
The discount rate sits higher than the fed funds rate, acting as a last resort for banks that can't borrow in the interbank market. There's also a secondary discount rate, even higher, for banks facing serious liquidity problems.
How the Federal Discount Rate Works
Beyond its other tools, the Fed lends directly to member banks and depository institutions as a lender of last resort to protect the stability of the banking system. Healthy banks can borrow what they need at short maturities from the discount window, making it a standing facility to avoid failures.
Normally, banks borrow from each other in the overnight market, but when liquidity needs spike or risks rise, they might not get funds there. That's when the discount window steps in as an emergency source to prevent collapses.
Borrowing from the Fed replaces interbank borrowing, and it's viewed as a last resort. The fed funds rate is usually lower, so banks prefer that option. This keeps discount lending minimal, just a backup for sound banks.
Three Discount Rates
You'll find discount lending split into primary or secondary credit, plus a seasonal rate for non-emergency needs in agricultural or seasonal communities.
Sound banks qualify for primary credit at the standard discount rate, processed through the discount window and reviewed every 14 days.
Secondary credit goes to banks in financial distress with severe liquidity issues, set 50 basis points above the primary rate as a penalty reflecting their weaker condition.
The Discount Rate and Monetary Policy
The discount rate helps prevent bank failures and serves as a tool for expansionary or contractionary policy.
Lowering it makes borrowing cheaper for banks, boosting credit and lending across the economy. Raising it increases costs, shrinking the money supply and curbing investment.
The Fed also uses open market operations in Treasuries and adjusts reserve requirements—the cash banks must hold from deposits—to influence money supply and rates.
Federal Discount Rate vs. Federal Funds Rate
The discount rate is what the Fed charges for its loans, set by the board of governors. The federal funds rate is what banks charge each other for reserve-balancing loans, targeted by the FOMC through Treasury trades but determined by the market.
Typically, the discount rate is 100 basis points higher to push banks toward mutual monitoring via interbank lending.
Frequently Asked Questions
- Why is the discount rate higher than the fed funds rate? It's set higher to make it a backup, encouraging banks to borrow from each other first.
- Why does the Fed change the discount rate? To control economic activity—raising it fights inflation, lowering it spurs growth during weakness.
- Which is more important, the discount rate or fed funds rate? The fed funds rate has broader impact, influencing many other rates, while the discount rate is more limited.
The Bottom Line
The federal funds rate targets overnight interbank lending, shaped by market forces with Fed influence via operations. The discount rate, higher and set directly by the Fed, provides a safety net for banks unable to borrow elsewhere.
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