Group 19- Analysis of the FED’s federal discount rates over the last 10 years

Federal Reserve System (FED)

The central bank of the United States is the FED. FED stands for Federal Reserve System but this is also referred to as the Federal Reserve for short. Although the FED is an independent government institution, the American central bank is owned by a number of large banks and therefore not by the state. The main governing body of the FED is the Board of Governors which consists of 7 members who are appointed by the President of the United States. In addition to the national FED there are 12 regional Reserve Banks. 5 representatives of these regional reserve banks together with the 7 members of the board of governors make up the FOMC (Federal Open Market Committee). The primary responsibility of the FOMC is to supervise open market operations through monetary policy. One important responsibility of the Federal Reserve is to safeguard the stability of the United States’ financial system. The FED also has various other functions, including:

  • ‘managing’ the national money supply by means of monetary policy with the aim of:
  • supervision and regulation of the private banks;
  • strengthening the United States’ position in the global economy;
  • preventing or resolving banking panics.

The Federal discount rate                                                   

The federal discount rate refers to the interest at which an eligible financial institution may borrow funds directly from a Federal Reserve bank. 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.

In other words, the Federal Reserve discount rate is how much the U.S central bank charges its member banks to borrow from its discount window to maintain the reserve it requires. The Fed Board of Governors raised the rate to 0.75 percent on December 14, 2016.

There are three discount rates:

  • The primary credit rate is the basic interest rate charged to most banks.
  • The secondary credit rate is a higher rate that is charged to banks that do not meet the requirements needed to achieve the primary rate.
  • The seasonal rate is for small community banks that need a temporary boost in funds to meet local borrowing needs. That may include loans for farmers, students, resorts and other seasonal activities.

Analysis of the Federal discount rate over the last 10 years

The chart below shows a simple comparison of the Discount Rate and the FED Fund rate over the past 10 years. Few things jump out: before the crisis started in 2007, the spread between the Fed funds target rate (5.25%) and the primary credit, aka discount rate, which was a 6.25%, was 100 bps. The first notable action that the Fed did vis-a-vis the discount rate was to cut it by 50 bps to 5.25% on the morning of August 17, 2007 (in the heyday of the quant implosion when the market was gyrating like a drunken sailor courtesy of busted quant models at GS Alpha and other core quant shops). The spread was subsequently cut to 25 bps on March 16, 2008, when Bear was unceremoniously handed over to JP Morgan for pennies on the dollar. It remained there until Thursday, when it has again moved to 50 bps. Looking at the chart demonstrates that there has been not one period over the past decade when there was a substantial widening divergence ever since January 9, 2003, when the current discount rate system (primary, secondary) took over the old system in which adjustment credit, extended credit and seasonal credit were the primary forms of crediting available to depository institutions (which in itself is of course an anachronism – only some of the current Discount Window institutions are, in fact, depository institutions, but that is the topic of another rant).

Explanation of the discount rate increase: