Federal Reserve cuts the discount rate

by Philip Brewer on 17 August 2007 2 comments

In response to the recent credit squeeze, the Federal Reserve did something unusual: they cut the discount rate without cutting the federal funds rate.

The federal funds rate is the rate at which banks lend to one another. The discount rate is the rate at which the Fed itself will lend money to banks. For the past few years, the Fed has closely coordinated changes in these rates, so to change one without changing the other is a departure.

Interesting history of fed funds and discount rate

Until the late 1960s the discount rate acted as a ceiling on the fed funds rate. The logic was that a bank that needed reserves could always get them from the Fed, so the only reason that it would pay more than the discount rate would be if it had tried to borrow from the Fed and been turned down--which would only happen if the bank were not sound.

In the late 1960s, though, things changed. Banks had profitable business opportunities that the Fed was disinclined to support. To get the reserves they needed, they went ahead and bid up the fed funds rate. From that point until 2003, the fed funds rate was generally higher than the discount rate. Of course, that made borrowing at the discount rate attractive--cheap funds make for more bank profit. The Fed rationed the funds through moral suasion--by asking uncomfortable questions and making it clear that the discount window was for emergencies and special situations, not as a source of cheap funds for higher profits.

The Fed was never really happy with rationing discount borrowing through moral suasion. In 2003 it changed the rules, setting the discount rate above the fed funds rate, and promising that the uncomfortable questions would end. Since the rate was above the market rate, there was no need to ration funds, and because the whole purpose of the Fed was to stand behind sound banks, any sound bank that was suffering some sort of temporary embarrassment in borrowing reserves would have access to ample funds.

How the discount window works

The discount window got its name because it used to work by "discounting" loans. The bank would show up at the window with some sound loans to its customers and sell them to the Fed at a discount--with the proceeds going to augment the bank's reserves. Transactions today are usually treated as a loan from the Fed to the bank, but they are still collateralized with bank assets, which can include customer loans.

The goal is to ensure that the banks can keep lending money to good credit risks, even when credit conditions tighten up. Nowadays banks make large loans expecting to sell them to investors. During a credit squeeze, the market for reselling loans can dry up. With so much of its money tied up in large loans that they can't sell, the bank would have to stop lending. But, with access to the discount window, the bank can essentially sell the loan (temporarily) to the Fed, allowing it to continue doing business until credit conditions return to normal.

In that sense, things are working exactly as they should.

Sensible move

In my view, this is a sensible move by the Fed. By keeping the federal funds rate stable, they're avoiding the "moral hazard" of bailing out people who made risky investments. By lowering the discount rate, they're making sure that banks can continue doing business, even during a credit squeeze.

Since very little money is actually borrowed at the discount window (even with the cut, the rate is still above the fed funds rate, making it an unattractive source of funds), the impact on the real economy is small, and yet it shows that the Fed is taking the situation seriously. That has calmed markets some, without doing much harm in terms of boosting inflation or bailing out the big risk-takers.

Ordinary investors and borrowers

The move doesn't have much implications for ordinary investors and borrowers. Most of your interest rates--even the floating rates--aren't tied to the discount rate.

If you have money that you've borrowed at floating rates, check to see what the rate is pegged to--the prime rate is common, but there are other base rates--and make a point of keeping an eye on that rate. So far the prime rate hasn't changed, and the Fed's action seems to suggest that it won't let these problems force rates higher, but you should still monitor the situation.

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Guest's picture

I think we will see a 50 cut between now and Sept 18th and then 2 more 25 basis points lopped off before the end of the year. A normal Fed reaction - tighten too quickly, wait too long, then loosen too quickly.

Philip Brewer's picture

I haven't yet seen enough of the Bernanke Fed to make a prediction. If the discount rate cut is a signal of further rate cuts to come, then we need to worry about the future value of the dollar. But if it's a substitute for more significant cuts, then it's a really clever move that preserves the value of the dollar while calming markets.

I'm afraid it's a "time will tell" kind of situation.