What is the Federal Discount Rate?
The Federal discount rate is the rate that central banks charge banks and deposit-taking institutions that borrow money from the central bank.
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. It is an important part of the discount window in the Federal Reserve system; we will also examine the importance of the relationship between them.
- The Federal discount rate is the interest rate that is charged to large central banks in the U.S. by the Federal Reserve to support regional and international financial markets.
- The three types of rates are Primary Credit, Secondary Credit, and Seasonal Credit.
- The federal discount rate is an important part of the discount window as a part of the overall Federal Reserve System.
Are There Different Types of 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.
1. Primary Discount Rate
As of March 2020, the interest rate charged to banks and deposit-taking institutions throughout the US is 0.25%.
2. Secondary Discount Rate
When a financial institution or loan type does not meet the requirements of a primary rate, a rate that is typically half a percentage point higher is charged. Thus, the secondary discount rate in the U.S. is currently 0.75% (March 2020).
3. Seasonal Credit Rate
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.
The Federal Reserve System provides tailored rates for communities with unique requirements due to unique local economies.
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.
CFI offers the Certified Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: