Federal discount rate

Definition

The federal discount rate, also known as the discount rate or primary credit rate, is the interest rate at which eligible institutions can borrow short-term funds directly from the Federal Reserve’s discount window. 

What is the federal discount rate?

The primary purpose of the federal discount rate is to provide a mechanism for banks and credit unions to borrow funds from the Federal Reserve in times of need, typically on a short-term basis. By adjusting the discount rate, the Federal Reserve can influence the cost and availability of credit in the banking system, thereby impacting economic activity, inflation, and employment levels.

The discount rate is one of the tools used by the Federal Reserve to implement monetary policy objectives, along with open market operations (buying and selling government securities) and setting the federal funds rate.

Changes in the discount rate can have significant implications for monetary policy and the broader economy. Lowering the discount rate encourages borrowing by financial institutions, which can stimulate economic activity by increasing the availability of credit to businesses and consumers. Conversely, raising the discount rate can discourage borrowing and spending, helping to control inflationary pressures in the economy.

Federal discount rate vs. federal funds rate

The federal discount rate and the federal funds rate, both set by the Federal Reserve, serve different purposes. The federal discount rate is the interest rate for short-term loans from the Federal Reserve to commercial banks, used mainly for managing liquidity issues.

It’s typically higher than the federal funds rate, which is the rate at which banks lend reserve balances to each other overnight. The federal funds rate, influenced by the Federal Reserve, is a key tool for implementing monetary policy and controlling inflation. While the discount rate directly manages short-term bank liquidity, the federal funds rate affects broader economic activity.

Example of the federal discount rate

Let’s say that a commercial bank, ABC Bank, is experiencing a temporary shortage of funds due to unexpected withdrawals by its customers. To meet its liquidity needs, ABC Bank decides to borrow money from the Federal Reserve.

Upon contacting the Federal Reserve, ABC Bank learns that the current federal discount rate is set at 2%. This means that ABC Bank can borrow funds from the Federal Reserve at an interest rate of 2%.

ABC Bank decides to borrow $10 million from the Federal Reserve at the federal discount rate of 2%. Over the course of one month, ABC Bank must repay the principal amount of $10 million plus interest accrued at the rate of 2%.