What Is the Discount Rate?
What does a lower discount rate mean for you?
Elizabeth Carlassare
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What Is the Discount Rate?
Today’s topic is understanding what a lower discount rate means for you.
Samir in New Jersey called in with this question:
“Hi Money Girl. This is Samir. Today, the Federal Reserve, in an emergency action, lowered the discount rate. I guess they don’t normally do this and they did this because the stock market has been dropping. Can you explain what it is they lowered? What is this discount rate and why they would have done this before their next meeting? I’ve never heard of this before. Again, this is Samir from New Jersey and I love your show.
Thanks for the question, Samir!
What Is the Discount Rate?
Ok, to start off, what is the discount rate?
The discount rate is the interest rate a regional U.S. Federal Reserve bank charges to make loans to depositories (such as banks and credit unions) to meet temporary cash shortages. On Friday, August 17, 2007, the Federal Reserve lowered the discount rate by half a percent from 6.25 down to 5.75 percent. It was the first time the Fed approved an emergency cut to the discount rate since immediately following the attacks of Sept. 11, 2001. The Federal Reserve also extended the time that banks can take to repay the loans from one day up to 30 days. It also made the loans renewable.
A related term you’ll hear in the financial news is the discount window. The discount window is the lending the Federal Reserve does at the discount rate.
Don’t Confuse Rates
It’s pretty common for people to confuse the discount rate with the federal funds rate, but they’re not the same thing. The federal funds rate is the interest rate that banks charge each other for overnight loans. It’s currently 5.25% and it’s the rate that directly impacts the rate you pay on consumer loans, such as credit cards, car loans, and home equity lines of credit. The discount rate does not directly affect these sorts of consumer interest rates.
The Federal Open Market Committee (which includes the presidents of the 12 regional Federal Reserve Banks) sets the target for the federal funds rate and it’s typically about one percent lower than the discount rate. As a result, it’s more attractive for banks to borrow money from other banks before seeking funds from the Federal Reserve at the discount rate.
Typically, banks don’t borrow from the Fed’s discount window unless there’s a crisis and borrowing through normal channels becomes difficult. Although the Federal Reserve has made attempts to change the perception, the Fed’s discount window is considered the “lender of last resort” for banks and, as a result, there’s still a stigma associated with borrowing from it.
How Do Banks Make Money?
Banks are legally required to keep cash reserves. The reserve amount varies, but it’s typically equal to 10% of the total value of the checking accounts at the bank. So for every $10 you deposit in your checking account, the bank needs to keep one dollar, but it’s free to lend out the other $9 at interest. This is how banks make their money. When a bank’s reserves fall short, they need to raise money to make up the difference.
Banks Have Two Ways to Borrow
So remember, there are two ways banks can borrow money:
- They can borrow money from other banks at the federal funds rate, or
- They can borrow money directly from the Federal Reserve at the discount rate (which is higher than the federal funds rate).
It’s a Cut for the Banks (Not You)
So why did the Federal Reserve lower the discount rate?
The Fed lowered it in response to credit and stock market turmoil related to credit tightening as a result of concerns about subprime loans and the quality of U.S. mortgage-backed securities. Because of the sharp rise in mortgage defaults in 2007, banks are wary of loaning money to each other. They are concerned about the quality of the mortgages used as collateral. And many lenders and banks are short on cash because institutional investors have not been buying mortgage-backed securities.
But the Federal Reserve’s discount window accepts many forms of collateral, including mortgages and mortgage-backed securities. A lower discount rate makes it more attractive for banks to borrow the short-term cash they need rather than raise it by selling off assets they own.
Think about it this way: If your spiffy car were wrecked in an accident, you might need to pay for the repair even if you knew you would later be reimbursed by the insurance company. To pay your mechanic, you’d need some cash. You could raise that cash by selling some assets (like stocks), but you’d probably prefer to borrow it from a short-term line of credit.
In the same way, lowering the discount rate can make it easier for banks to get loans and (at least in theory) it can help curb stock market selling by financial institutions.
For more on how banks work, please refer to episode 43, about fractional reserve banking.
Cha-ching! That’s all for now, courtesy of Money Girl, your guide to a richer life.
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To learn more:
· Read The Creature from Jekyll Island by G. Edward Griffin
· Watch The Money Masters
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