Federal Discount Rate

What is the Federal Discount Rate?

The federal discount rate is the rate that central banks charge banks and deposit-taking institutions to borrow money from the central bank to deal with very short-term shortages of liquidity in meeting reserve requirements on a collateralized basis via a lending channel called the discount window.

In the U.S. and other economies throughout the globe, the central bank system plays a role in supporting the stability and liquidity of financial markets. They do this through the implementation of various types of fiscal and monetary policy.

When large commercial banks need to borrow money to support their cash positions and maintain liquidity with regards to retail and consumer finance operations, they turn to the central bank to utilize various types of loans to support their position.

In the U.S., the federal discount rate is the interest rate that is charged to large central banks by the Federal Reserve to support regional and international financial markets.

Types of Federal Discount Rates

In the U.S., the Federal Reserve offers different tiers of credit to financial and deposit-taking institutions that come with different discount rates that are fully secured by the Federal Reserve.

The three types of rates are primary credit, secondary credit, and seasonal credit. Generally, the rate on secondary credit is higher than that on primary credit, with seasonal credit being an average of select market rates. All Federal Reserve banks across different states keep the same rate in each tier. Current rates are published on the Fed’s discount window website.

The difference between primary and secondary credit is the creditworthiness of the borrowing member institution and both types of credit are for very short terms, mostly overnight. When a financial institution or collateral type does not meet the requirements of a primary rate, a rate that is typically half a percentage point higher is charged.

Seasonal discount rates exist to allow small banks or community credit organizations to meet their often-unique needs. Rural communities require different types of loans for farmers, resort, or vacation workers, as well as communities that primarily consist of students.

Seasonal credit rates can be longer-term but are for member institutions that experience large seasonal swings in loans and deposits.

As the Fed wants a depository institution to exhaust all other funding avenues before using the discount window, all three rates are priced higher than than the Fed Funds target rate (about 0.5% or 50 basis points for primary credit and 100 bps higher for secondary and seasonal credit).

Relationship Between the Discount Window and Discount Rate

To understand how the discount rate in the Federal Reserve System is used, it is critical to understand its relationship with the discount window.

Discount window is the term used to describe the lending done by the Federal Reserve Bank in the U.S. to deposit-taking institutions throughout the country. The window is a figurative term that describes the consistent liquidity between both entities and the free flow of cash between them.

The Federal Reserve bank aims to provide liquidity and access to funds whenever an institution needs it for various purposes.

Ultimately, the consistent flow of capital through the window ends up supporting individuals on main streets by providing greater access to funding for banks, which can, in turn, lend funds out in the form of small business and personal loans.

The discount window allows for greater liquidity in times of economic distress, like recessions or unforeseen disasters that can help support financial institutions that support the free flow of capital in the general population.

It is seen as critical to maintaining liquidity, as, without it, market turmoil could turn into economic disaster and lead to a longer-term depression of the financial markets. However, this sort of borrowing is less common as there is a stigma in the marketplace for using the discount window.

Additional Resources

Federal Reserve (the Fed)

Discount Rate

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Fiscal Policy

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