What is the Federal Discount Rate?

The federal discount rate refers to the interest rate set by the Central Bank - in the United States this is the Federal Reserve. 

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How is the Federal Discount Rate Used?

The Federal Discount Rate applies to loans which the central bank extended and offered to certified commercial banks like the Federal Reserve to control the money supply and is utilized to ensure equilibrium in the financial markets. Borrowing from the central bank substitutes borrowing from other commercial banks, and so it's discouraged as the final resort measure immediately the interbank overnight lending system has been surpassed. The Federal Reserve fixes this interbank rate, known as the Fed funds rate, which is always set at a lower rate than the discount rate. The Fed funds, as well as, the discount rates adjust to balance the demand for, and the supply of, currency reserves. For instance, supposing the reserves supply in the Fed funds market is more than the demand, then the funds rate drops, and supposing the reserves supply is less than the demand, then there is an increased funds rate. Once the Fed funds rate is lesser than the discount rate, commercial banks would prefer borrowing from a different commercial bank as against the Fed.

How Does the Federal Discount Rate Work?

Daily, as banks payout, as well as, receive funds, they might end up having more (or less) funds than they require to meet their reserve target. Banks possessing excess funds usually lend them overnight to other banks with insufficient funds, as against leaving those funds in their non-interest-bearing reserve accounts at the Fed or even as idle vault cash. Commercial banks and depository institutions that are in stable financial conditions can borrow from their regional Federal Reserve banks at a primary credit or discount rate. These loans are usually extended on an overnight basis in order for banks to meet their short-term liquidity requirements. Funds for commercial banks that are borrowed from the Fed to enhance their supply of money are processed via the discount window, and there is a review of the rates every fourteen days. The federal discount rate is a major economic indicator, in that most other interest rates move either up or down with it. Healthy banks are permitted to borrow whatever they want at very short maturities (always overnight) from the discount window of the Fed, and it's thus known as a standing lending facility. The discount rate is the interest rate on these primary credit loans, which is usually set higher than the rate target of federal funds, typically by 100 basis points (1 percentage point), because the central bank prefers banks borrowing from one another in order for them to always monitor one another for credit risk, as well as, liquidity. Thus, in most situations the discount lending amount under the primary credit fairy is extremely small, intended only to be a backup liquidity source for strong banks in order for the federal funds rate not to ever rise way above its target - theoretically, it puts a ceiling on the Fed funds rate so as to equal the discount rate. Secondary credit is given to banks experiencing financial crisis and severe liquidity challenges. The interest rate of the central bank is set at 50 basis points (0.5 percentage points) above the discount rate. A higher penalty rate is set to the interest rate on these loans in order to show the less-sound situation of these borrowers. Under normal conditions, the discount rate sits between the secondary credit rate and the Fed Funds rate. For instance: Fed funds rate is 1% while the discount rate is 2%, then the secondary rate is 2.5%.

Federal Reserve Monetary Tools

The federal discount rate is utilized as a tool for either simulating (expansionary monetary policy) or reining in (contractionary monetary policy) the economy. A decreased discount rate makes it less expensive for commercial banks to borrow money, thereby resulting in increased available credit and lending activity all over the economy. On the other hand, an increased discount rate makes it costlier for banks to borrow, thereby diminishing the money supply while retracting investment activity. Asides setting the discount rate, the Federal Reserve is capable of influencing the money supply, credit and also interest rates via open market operations (OMO) in the United States treasury markets, and by lowering or raising reserve requirements for private banks. The reserve requirement is the part of a bank's deposits which it must hold as cash, either within its vaults or on deposit at its regional Federal Reserve banks. The higher the reserve needs, the fewer room banks need to leverage their deposits or liabilities. Higher reserve needs are more normal during a recession when a central banks needs to make sure that banking panics and runs do not result in financial failures. The Federal Reserve acts on its dual mandate in order to maximize employment and also lessen inflation. The Federal Reserve's board of governors determines the discount rate, as against the federal funds rate, which the Federal Open Markets Committee (FOMC) set. The FOMC sets the Fed funds rate via the open sale and purchase of U.S. treasuries, while the discount rate is achieved only via review by the board of governors.