Federal discount rate:
The interest rate at which an eligible financial institution may borrow funds directly from a Federal Reserve bank. Banks whose reserves dip below the reserve requirement set by the Federal Reserve’s board of governors use that money to correct their shortage. The board of directors of each reserve bank sets the discount rate every 14 days. It’s considered the last resort for banks, which usually borrow from each other.
The Fed uses the discount rate to control the supply of available funds, which in turn influences inflation and overall interest rates. The more money available, the more likely inflation will occur. Raising the rate makes it more expensive to borrow from the Fed. That lowers the supply of available money, which increases the short-term interest rates. Lowering the rate has the opposite effect, bringing short-term interest rates down.
The Discount Rate since 1950:
The Discount Rate for the last 10 years:
As can be observed in the first graph, the FED’s discount rate has been at a historical low since the 1950’s. Slowly growing since 2009, it remains at an incredible 1,25% to date.
The second graph clearly shows how the financial crisis of 2007/2008 forced the FED to lower the rate at which banks could borrow money. In an attempt to spark the economy by facilitating the flow of money in the country, the FED has maintained a very low rate since the crisis.
it is also interesting to note that between 2010 and 2016 theres was no hike of the discount rate (it stayed at 0,75%, a historical low). 2016 and 2017 however, represented a 0,25% hike respectively – symbolising economic stability and recovery.
Janet Yellen, chairman of the FED testified before the Senate Banking Committee last Tuesday and the House Financial Services Committee Wednesday in her first semiannual monetary policy report to the new administration.
In her testimony, Yellen struck all the right notes:
- The need to restore the federal discount rate — the interest rate charged to commercial banks for loans from their regional Federal Reserve Bank — as the active monetary policy tool again without waiting too long.
- The plan to reduce the federal reserve balance sheet in a predictable and orderly manner after confidence that the discount rate is once again effective in affecting monetary policy is restored.
- Commitment to work with any new regulatory supervision chief and the Treasury to reduce regulatory burden and support fiscal policy.
- Fiscal policy should be good for the country and not bust our budget.
- Loss of access to healthcare will have an impact on consumer spending.
So, where do we go from here? Depending on how the economy develops and how fast fiscal policy is shaped up and pushed through, the Fed might be able to affect three rate hikes this year. They will surely need more time to gain enough confidence to start reducing the federal reserve balance sheet.