The Discount Rate
The discount rate is the second monetary policy tool or instrument used by the Federal Reserve to control the level of bank reserves (and thus the money supply or interest rates). As defined above, the discount rate is the rate of interest Federal Reserve Banks charge on loans to financial institutions in their district. The Federal Reserve can influence the level and price of reserves by changing the discount rate it charges on these loans.
Specifically, changing the discount rate signals to the market and the economy that the Federal Reserve would like to see higher or lower rates in the economy. Thus, the discount rate is like a signal of the FOMC’s intentions regarding the tenor of monetary policy. For example, raising the discount rate signals that the Fed would like to see a tightening of monetary conditions and higher interest rates in general (and a relatively lower amount of borrowing). Lowering the discount rate signals a desire to see more expansionary monetary conditions and lower interest rates in general
For two reasons, the Federal Reserve has rarely used the discount rate as a monetary policy tool. First, it is difficult for the Fed to predict changes in bank discount window borrowing when the discount rate changes. There is no guarantee that FIs will borrow more (less) at the discount window in response to a decrease (increase) in the discount rate. Thus, the exact direct effect of a discount rate change on the money supply is often uncertain. The In the News box in this section demonstrates how in August 2007, the Fed’s lowering of the discount rate to calm financial markets battered by deteriorating conditions in the mortgage and other debt markets resulted in little effect on the borrowing by banks. However, the Fed’s lowering of the fed funds rate less than a month later resulted in a surge in discount window borrowing.
Second, because of its “signaling” importance, a discount rate change often has great effects on the financial markets. For example, the unexpected decrease in the Fed’s discount rate (to 0.50 percent) on December 16, 2008, resulted in a 359.61 point increase in the Dow Jones Industrial Average, one of the largest one-day point gains in the history of the Dow and one of a handful of up days during the height of the financial crisis. Moreover, virtually all interest rates respond in the same direction (if not the same amount) to the discount rate change. For example, Figure 4–3 shows the correlation in four major U.S. interest rates (discount rate, prime rate [the rate banks charge to large corporations for short-term loans], three-month CD rate, and three-month T-bill rate) from 1997 through July 2010
The discount rate is the second monetary policy tool or instrument used by the Federal Reserve to control the level of bank reserves (and thus the money supply or interest rates). As defined above, the discount rate is the rate of interest Federal Reserve Banks charge on loans to financial institutions in their district. The Federal Reserve can influence the level and price of reserves by changing the discount rate it charges on these loans.
Specifically, changing the discount rate signals to the market and the economy that the Federal Reserve would like to see higher or lower rates in the economy. Thus, the discount rate is like a signal of the FOMC’s intentions regarding the tenor of monetary policy. For example, raising the discount rate signals that the Fed would like to see a tightening of monetary conditions and higher interest rates in general (and a relatively lower amount of borrowing). Lowering the discount rate signals a desire to see more expansionary monetary conditions and lower interest rates in general
For two reasons, the Federal Reserve has rarely used the discount rate as a monetary policy tool. First, it is difficult for the Fed to predict changes in bank discount window borrowing when the discount rate changes. There is no guarantee that FIs will borrow more (less) at the discount window in response to a decrease (increase) in the discount rate. Thus, the exact direct effect of a discount rate change on the money supply is often uncertain. The In the News box in this section demonstrates how in August 2007, the Fed’s lowering of the discount rate to calm financial markets battered by deteriorating conditions in the mortgage and other debt markets resulted in little effect on the borrowing by banks. However, the Fed’s lowering of the fed funds rate less than a month later resulted in a surge in discount window borrowing.
Second, because of its “signaling” importance, a discount rate change often has great effects on the financial markets. For example, the unexpected decrease in the Fed’s discount rate (to 0.50 percent) on December 16, 2008, resulted in a 359.61 point increase in the Dow Jones Industrial Average, one of the largest one-day point gains in the history of the Dow and one of a handful of up days during the height of the financial crisis. Moreover, virtually all interest rates respond in the same direction (if not the same amount) to the discount rate change. For example, Figure 4–3 shows the correlation in four major U.S. interest rates (discount rate, prime rate [the rate banks charge to large corporations for short-term loans], three-month CD rate, and three-month T-bill rate) from 1997 through July 2010
In general, discount rate changes are used only when the Fed wants to send a strong message to financial markets to show that it is serious about wanting to implement new monetary policy targets. For example, Federal Reserve Board members commented that the December 16, 2008, discount rate change was taken in light of a deterioration in labor market conditions and a decline in consumer spending, business investment, and industrial production. Further, financial markets remained quite strained and credit conditions tight. The Board commented that overall, the outlook for economic activity had weakened further. Thus, this drop in the discount rate was intended to signal the Fed’s strong and persistent intention to allow the money supply to increase and to stimulate economic growth. The discount rate stayed at this historical low until February 2010, when the Fed raised the rate to 0.75 percent.
Historically, discount window lending was limited to depository institutions (DIs) with severe liquidity needs. The discount window rate, which was set below the fed funds rate, was charged on loans to depository institutions only under emergency or special liquidity situations (see Figure 4–3 , 1990–2002). However, in January 2003, the Fed implemented changes to its discount window lending that increased the cost of borrowing but eased the terms. Specifically, three lending programs are now offered through the Fed’s discount window. Primary credit is available to generally sound depository institutions on a very short-term basis, typically overnight, at a rate above the Federal Open Market Committee’s target rate for federal funds. Primary credit may be used for any purpose, including financing the sale of fed funds
Primary credit may be extended for periods of up to a few weeks to depository institutions in generally sound financial condition that cannot obtain temporary funds in the financial markets at reasonable terms. Secondary credit is available to depository institutions that are not eligible for primary credit. It is extended on a very short-term basis, typically overnight, at a rate that is above the primary credit rate. Secondary credit is available to meet backup liquidity needs when its use is consistent with a timely return to a reliance on market sources of funding or the orderly resolution of a troubled institution. Secondary credit may not be used to fund an expansion of the borrower’s assets. The Federal Reserve’s seasonal credit program is designed to assist small depository institutions in managing significant seasonal swings in their loans and deposits. Seasonal credit is
available to depository institutions that can demonstrate a clear pattern of recurring intrayearly swings in funding needs. Eligible institutions are usually located in agricultural or tourist areas. Under the seasonal program, borrowers may obtain longer-term funds from the discount window during periods of seasonal need so that they can carry fewer liquid assets during the rest of the year and make more funds available for local lending.
With the change, discount window loans to healthy banks would be priced at 1 percent above the fed funds rate rather than below, as it generally was in the period preceding January 2003. Note in Figure 4–3 the jump in the discount window rate in January 2003. Loans to troubled banks would cost 1.5 percent above the fed funds rate. The changes were intended not to change the Fed’s use of the discount window to implement monetary policy, but to significantly increase the discount rate while making it easier to get a discount window loan. By increasing banks’ use of the discount window as a source of funding, the Fed hopes to reduce volatility in the fed funds market as well. The change also allows healthy banks to borrow from the Fed regardless of the availability of private funds. Previously, the Fed required borrowers to prove they could not get funds from the private sector, which put a stigma on discount window borrowing. With the changes, the Fed lends to all banks, but the subsidy of below fed fund rate borrowing is gone.
The Fed took additional unprecedented steps, expanding the usual function of the discount window, to address the financial crisis. While the discount window had traditionally been available only to DIs, in the spring of 2008 (as Bear Stearns nearly failed) investment banks gained access to the discount window through the Primary Dealer Credit Facility (PDCF). In the first three days, securities firms borrowed an average of $31.3 billion per day from the Fed. The largest expansion of the discount window’s availability to all FIs occurred in the wake of the Lehman Brothers’ failure, as a series of actions were taken in response to the increasingly fragile state of financial markets. After March 2008, several new broad-based lending programs were implemented, providing funding to a wide array of new parties, including U.S. money market mutual funds, commercial paper issuers, insurance companies, and others. These programs rapidly expanded the current lending programs offered via the Fed.
During the financial crisis, the Fed also significantly reduced the spread (premium) between the discount rate and the federal funds target to just one-quarter of a point, bringing the discount rate down to one-half percent. With lower rates at the Fed’s discount window and interbank liquidity scarce as many lenders cut back their lending, more financial institutions chose to borrow at the discount window. The magnitude and diversity of nontraditional lending programs and initiatives developed during the crisis were unprecedented in Federal Reserve history. The lending programs were all designed to “unfreeze” and stabilize various parts of the credit markets, with the overall goal that parties receiving credit via these new Fed programs would, in turn, provide funding to creditworthy individuals and firms.
Historically, discount window lending was limited to depository institutions (DIs) with severe liquidity needs. The discount window rate, which was set below the fed funds rate, was charged on loans to depository institutions only under emergency or special liquidity situations (see Figure 4–3 , 1990–2002). However, in January 2003, the Fed implemented changes to its discount window lending that increased the cost of borrowing but eased the terms. Specifically, three lending programs are now offered through the Fed’s discount window. Primary credit is available to generally sound depository institutions on a very short-term basis, typically overnight, at a rate above the Federal Open Market Committee’s target rate for federal funds. Primary credit may be used for any purpose, including financing the sale of fed funds
Primary credit may be extended for periods of up to a few weeks to depository institutions in generally sound financial condition that cannot obtain temporary funds in the financial markets at reasonable terms. Secondary credit is available to depository institutions that are not eligible for primary credit. It is extended on a very short-term basis, typically overnight, at a rate that is above the primary credit rate. Secondary credit is available to meet backup liquidity needs when its use is consistent with a timely return to a reliance on market sources of funding or the orderly resolution of a troubled institution. Secondary credit may not be used to fund an expansion of the borrower’s assets. The Federal Reserve’s seasonal credit program is designed to assist small depository institutions in managing significant seasonal swings in their loans and deposits. Seasonal credit is
available to depository institutions that can demonstrate a clear pattern of recurring intrayearly swings in funding needs. Eligible institutions are usually located in agricultural or tourist areas. Under the seasonal program, borrowers may obtain longer-term funds from the discount window during periods of seasonal need so that they can carry fewer liquid assets during the rest of the year and make more funds available for local lending.
With the change, discount window loans to healthy banks would be priced at 1 percent above the fed funds rate rather than below, as it generally was in the period preceding January 2003. Note in Figure 4–3 the jump in the discount window rate in January 2003. Loans to troubled banks would cost 1.5 percent above the fed funds rate. The changes were intended not to change the Fed’s use of the discount window to implement monetary policy, but to significantly increase the discount rate while making it easier to get a discount window loan. By increasing banks’ use of the discount window as a source of funding, the Fed hopes to reduce volatility in the fed funds market as well. The change also allows healthy banks to borrow from the Fed regardless of the availability of private funds. Previously, the Fed required borrowers to prove they could not get funds from the private sector, which put a stigma on discount window borrowing. With the changes, the Fed lends to all banks, but the subsidy of below fed fund rate borrowing is gone.
The Fed took additional unprecedented steps, expanding the usual function of the discount window, to address the financial crisis. While the discount window had traditionally been available only to DIs, in the spring of 2008 (as Bear Stearns nearly failed) investment banks gained access to the discount window through the Primary Dealer Credit Facility (PDCF). In the first three days, securities firms borrowed an average of $31.3 billion per day from the Fed. The largest expansion of the discount window’s availability to all FIs occurred in the wake of the Lehman Brothers’ failure, as a series of actions were taken in response to the increasingly fragile state of financial markets. After March 2008, several new broad-based lending programs were implemented, providing funding to a wide array of new parties, including U.S. money market mutual funds, commercial paper issuers, insurance companies, and others. These programs rapidly expanded the current lending programs offered via the Fed.
During the financial crisis, the Fed also significantly reduced the spread (premium) between the discount rate and the federal funds target to just one-quarter of a point, bringing the discount rate down to one-half percent. With lower rates at the Fed’s discount window and interbank liquidity scarce as many lenders cut back their lending, more financial institutions chose to borrow at the discount window. The magnitude and diversity of nontraditional lending programs and initiatives developed during the crisis were unprecedented in Federal Reserve history. The lending programs were all designed to “unfreeze” and stabilize various parts of the credit markets, with the overall goal that parties receiving credit via these new Fed programs would, in turn, provide funding to creditworthy individuals and firms.
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