The discount rate is the interest rate charged by the FEDERAL RESERVE SYSTEM to member banks for short-term loans. Changing the discount rate is one of three “tools” used by the Federal Reserve (known as the Fed) to manage the MONEY SUPPLY. The discount rate is not a major tool; rather it is more of a “pencil tool.” Like a builder changing the construction plans, changing the discount rate is a signal that the Fed is encouraging or discouraging banks to make more loans. Banks are expected to exhaust alternative sources before the Fed provides discount-rate credit. Discount-rate borrowing is closely scrutinized. Excessive borrowing suggests a bank is not carefully managing its funds, and frequent borrowing might lead to closer evaluation of a bank’s business activities by the Federal Reserve. In the Fed’s early days, banks would borrow funds for their short-term liquidity needs at the discount window of the New York Federal Reserve. In recent years, as banks have become better at managing their cash needs, fewer have utilized the Fed’s borrowing at the discount window. A falling discount rate encourages banks to make more loans and signals that the Fed is practicing expansionary MONETARY POLICY. A rising discount rate signals contractionary monetary policy. After September 11, 2001, the Federal Reserve publicly announced the discount window was available to provide liquidity to the BANKING SYSTEM. With the stock exchanges closed and major banks scrambling to reestablish operations, there was a liquidity problem in U.S. financial markets. The Fed stepped in to provide liquidity by providing loans through the discount window. As reported in the Wall Street Journal, that week the Fed loaned $45 billion, compared to a typical weekly amount in the range of $25–$300 million. By opening up access to the discount window, the Fed was attempting to reduce volatility in the FEDERAL FUNDS MARKET, the short-term (usually overnight) lending among U.S. banks to meet the Fed’s RESERVE REQUIREMENTS. Despite its name, the Federal Reserve does not operate or control the federal funds market. The Fed requires banks to keep a set percentage of their deposits as cash or other specified U.S. TREASURY SECURITIES. These required reserves, which are available when customers want their deposits returned, act as a source of liquidity for banks. As banks receive more deposits, their reserve requirements increase. At the end of each business day, bank managers calculate their required reserves, determine whether they have excess or insufficient reserves, and lend or borrow reserves electronically in the federal funds market. Loans made in the federal funds market are returned the next business day. Banks borrowing to meet their reserve requirement will compare rates in the market, attempting to minimize their costs. Federal funds rates tend to be uniform among participating banks and increase or decrease, depending on the demand for and supply of funds available. In 2002 the Fed announced it would change its discount- rate policies. Federal Reserve governor Edward Gramlich was quoted as saying, “There is an alleged stigma to the discount window, and we intend to get rid of that.” The Fed proposed setting the discount rate 1 percent above the targeted federal funds rate. Financially sound banks would be allowed to borrow at the new rate with “few questions asked and without requiring a bank to first exhaust alternatives.” With the discount rate above the federal funds rate, banks will not likely borrow, but if a financial crisis arose, raising the federal funds rate temporarily, banks could borrow at the discount window, reducing pressure in the federal funds market. The new Fed proposal would also allow less financially sound banks to borrow at a rate one-half percentage point above the primary discount rate. The Fed goal is to reduce interest-rate volatility.
See also OPEN MARKET OPERATIONS.