The Basics

The Discount Rate and What it’s all About

Some of you out there might not realize that the Federal Reserve actually sets two different rates. The one that gets the most press and is generally referred to is the Federal Funds (Fed Funds) target rate. When you hear about the Fed raising or lowering interest rates, it almost always means a change in the Fed Funds rate.

The Fed Funds rate is an overnight interest rate between banks when they borrow and/or lend reserves to each other. Reserves are what banks are required to keep on deposit with the Federal Reserve based on a fraction of the deposits they have from customer accounts. Those requirements change with in and outflows to the banks, so at points some banks will have excess reserves and others shortfalls. Those with the excess reserves lend to those who need to make up the difference between what they have and what they are required to have. The Fed Funds rate is the interest rate the lenders of reserves charge the borrows of them.

As I noted in Liquidity, Fed Action, and all that Stuff, the Fed Funds rate moves based on supply and demand and the Fed acts to try to keep the rate in line with its target.

The Discount Rate is something the Fed tends to move less frequently. That is the one which got lowered this morning.

The Fed’s Discount Window is a back-up to the Fed Funds market and essentially is how the Fed becomes the lender of last resort. Banks in need of reserves can go to the window to borrow those reserves directly from the Fed if they cannot get them in the Fed Funds market (click here for more details). Thus, through the Discount Window the Fed can provide the market with needed liquidity, which is what has been the big problem of late.

Until today, the Discount Rate was 100 basis points (one full percentage point) higher than the Fed’s target Fed Funds rate. Basically that means banks forced to used the Discount Window were faced with a 100 basis point penalty (give or take) for not being able to get the reserves they need through the Fed Funds market. By cutting the Discount Rate today, the Fed essentially cut that penalty in half.

Now the Fed doesn’t just shell out cash at the Discount Window. They require collateral for the loans. Today, in addition to the cut in the Discount Rate the Fed also widened the the array of securities permissible for use as collateral. On top of that, they also lengthened the maximum possible loan time. All of that together will help provide more liquidity to a market that was desperately in need of it.

By John

Author of The Essentials of Trading