Federal Discount Rate

Key points
* The federal discount rate is the interest rate the Federal Reserve charges banks and other depository institutions for short-term loans from a Federal Reserve Bank’s discount window.
* It is set by the Fed’s Board of Governors and used as a lender-of-last-resort tool to provide liquidity and support financial stability.
* The discount rate is normally higher than the federal funds rate and is intended to discourage routine use of the discount window.

What the discount rate is and why it exists

The discount rate is the price the Federal Reserve charges eligible institutions to borrow directly from a regional Federal Reserve Bank. Its main purposes are:
* Provide an emergency backstop when banks cannot obtain funds in the interbank market.
* Prevent liquidity shortages that could lead to bank failures or broader financial instability.
* Serve as one instrument of monetary policy to influence credit conditions and the money supply.

Borrowing from the Fed is typically very short-term (often overnight) and is designed as a temporary fix for liquidity problems rather than a regular funding source.

How it works

• Under normal conditions, banks prefer borrowing from each other in the overnight interbank market.
• If a bank cannot obtain enough reserves from other banks, it can turn to the Fed’s discount window for funds.
• Because borrowing at the discount window signals a bank’s vulnerability, the discount rate is normally set above interbank rates to encourage banks to seek market funding first.
• The Fed uses the discount window selectively so that total discount lending remains small in most periods.

The three types of discount credit

The Fed distinguishes among three discount-window loan rates:
* Primary credit: Available to depository institutions in generally sound financial condition; this is the standard discount rate for short-term emergency borrowing.
* Secondary credit: Extended to institutions with demonstrated financial weaknesses at a higher, penalty rate (commonly set above the primary rate, historically around 50 basis points).
* Seasonal credit: Intended for smaller institutions with predictable, seasonal swings in funding needs (for example, agricultural lenders).

Role in monetary policy

Adjusting the discount rate affects banks’ cost of emergency borrowing and can influence broader credit conditions:
* Lowering the discount rate makes borrowing from the Fed cheaper, which can expand available credit and support lending (expansionary effect).
* Raising the discount rate makes borrowing from the Fed more expensive, which can dampen lending and help restrain inflationary pressure (contractionary effect).

The Fed also implements policy through other tools—most notably open market operations and reserve requirements—which typically have larger and more direct effects on interest rates and the money supply.

Discount rate vs. federal funds rate

Although related, the discount rate and the federal funds rate are different:
* Discount rate: Set by the Fed’s Board of Governors and applied to loans from the Fed’s discount window.
* Federal funds rate: The market rate at which banks lend excess reserves to one another overnight; the Federal Open Market Committee (FOMC) sets a target for this rate, and the Fed uses open market operations to influence it.

Because the discount rate is intended as a backstop, it is generally set higher than the federal funds rate target to discourage routine use of Fed loans and to encourage interbank lending and private-sector monitoring of credit risk.

Why the Fed changes the discount rate

The Fed adjusts the discount rate as part of broader efforts to influence economic activity and financial stability:
* Raise rates to cool an overheating economy and reduce inflationary pressure.
* Lower rates to stimulate borrowing, investment, and economic activity during slowdowns or recessions.
Decisions about the discount rate are coordinated with other policy actions to achieve the Fed’s dual mandate of maximum employment and price stability.

Which matters more for the economy?

The federal funds rate (and the FOMC’s target for it) typically has a greater and more immediate impact on overall interest rates throughout the economy—mortgages, consumer loans, and many short-term instruments are more directly tied to the fed funds market. The discount rate is important for financial stability and as a backstop, but its direct influence on everyday borrowing costs is usually more limited.

Conclusion

The federal discount rate is a key tool that enables the Federal Reserve to provide short-term liquidity to banks and maintain stability in the financial system. While it is less central than the federal funds rate for day‑to‑day interest-rate movements, the discount window and its pricing remain an important part of the Fed’s crisis-prevention and monetary-policy toolkit.