The Fed just raised the discount rate–what does it mean?

The discount rate is going up to .75%

After the close of stock market trading yesterday, the Federal Reserve announced that it was going to raise the discount rate from .5% (annual rate) to .75%, effective today.  It will also limit the maturity of “discount window” loans to overnight, effective March 18th.  Previous policy allowed loans of up to 90 days.

What does this mean?

Some background

the Fed Funds rate

Federal banking laws require that each bank keep deposits, called reserves, with the central bank equal to a specified proportion of the loans it makes.  The proportion varies with the kind of loan.

Banks don’t always have the exact amount of money they need to have on deposit with the Fed.  Some have more than they need, some less.  Under normal circumstances they borrow and lend with each other in the market for overnight bank deposits, called the Federal Funds market.

The Fed uses this market as its principal tool for setting money policy.  It announces its desired level for the fed funds rate.  The Fed also trades in this market as necessary to keep the rate at the designated level.  The current fed funds policy, which is to keep that rate under .25%/year, remains unchanged by the rise in the discount rate.

the discount rate

The Fed has another tool for controlling short-term rates, the rate for borrowing funds directly from the Fed rather than from other banks.  This rate, which was a prominent Fed tool a generation ago but is no longer particularly relevant, it called the discount rate. Banks who use this rate are said to be going to the Fed’s “discount window.”

Under normal circumstances, the discount rate is higher than the fed funds rate.  Just before the financial crisis, the discount rate was 1% more.  Banks have no absolute right to borrow from the discount window, but must ask the Fed for permission to do so.  Discount window borrowing normally carries a stigma with it, since it implies that the bank in question has either hugely messed up its planning of reserve deposits, or that other banks are unwilling to lend to it.  Serial discount window borrowers may face Fed disciplinary action.

The situation up until today

With the onset of the financial crisis in 2007, interbank lending, even overnight lending, started to dry up.  At the height of the crisis, no one would buy bank commercial paper.  No one would lend in the fed funds market.  Therefore, banks couldn’t raise money to make loans to customers.  Even worse, banks that were borrowing to have money to meet minimum reserve requirements on outstanding loans were faced with the prospect of having to call in loans to satisfy the reserve rules with the cash they had on hand.

The Fed dealt with this mess by becoming an active lender to any and all member banks at the discount window, by lowering the premium over the fed funds rate, in stages, from 1% to .25% and ultimately extending the maturity of discount window loans from overnight to 90 days.

At the height of the financial crisis discount borrowing was extremely important, reaching well over $100 billion.  Today it has shrunk to less than $15 billion.

Why the changes?

Two reasons:

–the short-term lending market has pretty much returned to normal.  The only reason for a bank to borrow from the discount window today is that the rate is better than a weak bank could get in the open market.  By ending this subsidy, the Fed is sending a message to these institutions to get their houses in order.

–it’s a signal to the financial markets that the Fed intends to act responsibly and return money policy to normal when conditions are right.  Remember, in its announcement, the Fed stressed that for now the Fed Funds rate, the key policy rate, will remain unchanged.  The Fed has already withdrawn a couple of its support programs, but an increase in the discount rate is a much more visible step.  So it has much greater psychological value.

Market reaction

So far, reaction has been muted but slightly negative for stocks and positive for the dollar.  Treasury bonds are up, but that’s because of favorable inflation data announced this morning.

The rise in the discount rate will have no practical effect on world economies.  As a statement, I think it should be read as a mild positive, that the US economy is healthy enough that it no longer needs this support (which wasn’t doing that much any longer, anyway).  I think stock markets should be up on the news.

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