Whenever money is borrowed, it is subject to a rate of interest. Banks often lend money to each other, and the interest rate they charge is set by the Federal Reserve, which is the central bank for the United States. When commercial banks borrow directly from the Federal Reserve, the interest rate that is charged is known as the federal discount rate. It is the subject of much attention from economists and investors as both an indicator and a predictor of economic conditions.
The federal discount rate is higher than the federal funds rate, which is the interest that banks charge one another for short-term loans. The federal funds rate is also set by the Federal Reserve, but is not to be confused with the discount rate. Banks are required to have a certain amount of their total deposits on reserve as cash. When a bank gets below this required percentage, it will borrow overnight from other banks, or from the Federal Reserve as a last resort.
When we hear in the news that the Federal Reserve, also called the “Fed,” has raised or lowered interest rates, the federal discount rate is one of those rates. If interest rates, including the federal discount rate, are lowered, this makes it easier and cheaper for banks to obtain the money needed to meet their reserve requirement. If interest rates are raised, it is more costly for the banks to obtain funds. Whether it is expensive or inexpensive, in terms of interest, for banks to obtain loans is reflected in the interest that banking customers pay for loans.
For instance, it is easy to notice that mortgage interest rates increase or decrease incrementally along with the federal discount rate. Interest rates on certificates of deposit and savings accounts also fluctuate in the general direction of the discount rate. In practical terms, high and low interest rates translate respectively into the scarcity or availability of money in an economy.
The federal discount rate is so important precisely because it controls the availability of money. If there is “too much” money in an economy, rapid growth may occur, but price inflation also takes place, which can short-circuit economic growth if it gets out of hand. On the other hand, too little money has the effect of stifling otherwise healthy growth or preventing economic recovery in a depression or recession. Maintaining this delicate balance is the job of the Federal Open Market Committee, which decides when to raise or lower the federal discount rate, and by how much.