The federal discount rate is the interest rate at which a financial institution borrows funds directly from the Federal Reserve Bank. In the US, the discount rate, which acts as a reference for commercial banks, is one of the rates that the FED manipulates to control money supply, the second one being the Federal Funds Rate.
There are three types of discount rates: The primary credit rate, which is the interest rate charged to most banks, the secondary credit rate, a rate that is charged to small or regional banks and is usually a half point higher than the primary rate, and the seasonal rate which is debited to small community banks that need a temporary boost in funds to meet the local borrowing needs.
The Federal discount rate is set through a democratic process in which the Federal Open Market Committee meets eight times a year to decide whether banks will be able to lend out less or more money. For instance, if the discount rate is high, it is more expensive for banks to borrow funds. Thus, they have less cash to lend out. On the contrary, if the discount rate is low, banks can borrow more funds as they have more cash to lend out, making cheaper to obtain loans from the FED.
The FED raises the discount rate when it wants rates to increment, its main goal being to control inflation. This process is called contractionary monetary policy. As the Fed is supposed to regulate money supply, this policy helps to reduce the amount of funds available by limiting lendings. The expansionary monetary policy, on the other hand, is used to stimulate economic growth.
This article will analyze the Federal Reserve’s discount rates over the last 10 years. It will first examine the resolution of the year 2006 to the end of the crisis in 2009, then it will evaluate years 2010 to 2013, and finally it will explore recent years, from 2014 to this current year.
At the end of the year 2006, the discount rate was at the highest it has been during the last 10 years. Even if the real estate market was becoming weaker, many sectors continued to be strong. As a result, the board of directors decided to maintain the discount rate high, at 6.25%. Some directors believed that the economic growth was constant, and that inflation would continue to decrease. During the next six months the discount rate was maintained given the healthy overall look of the economy, however, many borrowers start having financial difficulties. Interest rates started rising, and they were no longer able to pay their mortgages back. Hence, many banks went bankrupt because of the high number of customers defaulting. These were the first signs of the worst financial crisis since 1929.
On September 17, 2007, the Federal Reserve decided to decrease the discount rate to 5.75%, but this measure was not sufficient to stop the financial crisis. The employment report acknowledged a shortage in labor supply, which was a sign of a weaker economy. The discount rate continued decreasing during the last six months of 2007, but the economy kept deteriorating as well as financial markets. Some directors believed that continuing to decrease the discount rate could help the economy’s recovery. Thus, by the end of the year 2007, the discount rate decreased to 4.75%.
The year 2008 started with a low discount rate of 3.50%, and continue diminishing throughout the year until it accounted for 0.50%. The reason is that many indicators of economic growth were performing poorly. The unemployment rate was high, whereas the manufacturing, housing and spending rates were very low. This year is known to have suffered the worst economic crisis since the Great Depression. The Federal Reserve resolved to lower the discount rate in order to increase liquidity, and improve the economic performance. As the prices for energy and basic commodities started falling, the board of directors decided to stimulate aggregate demand by increasing the amount of available cash.
At the beginning of the year 2009, the board of directors realized that the economy was weaker. As there was a lot of uncertainty about the economy’s future, the asset prices were high, and the efforts made by the government to improve liquidity were minimal. Financial markets continued to be affected whereas households, and corporations refrain from spending. A lack of credits also inhibited the economy’s recovery. For these reasons, the FED’s board of directors decided to maintain the discount rate small so that banks could lend more money, and strengthen the economic situation. By the end of the year 2009, the FED decided to establish an interest rate of 0.50%. The economy began to recover albeit unhurried. They previewed an unrushed economic recovery for the next coming years. According to the FED’s report of December 23rd, 2009, financial markets were performing better during the last months of this year, nevertheless, financial intermediaries were still having trouble equilibrating their balance sheets. The housing industry showed a recovery, however, this was only possible because of the money lent to first-time buyers. The employment rate continued to be low, but it was improving. At the end of the year 2009 the board of directors decided to maintain the discount rate small.
At the beginning of the year 2010, American Federal Reserve Banks changed their attitudes towards the monetary policy. As they were optimistic about the recovery of the American Economy, the FED established an increase on the primary credit rate of ¾. This discount rate remained until the end of 2015.
According to the Federal Open Market Committee, there was a moderate resurgence in the American Economy during this period. The Federal Reserve website states that “although the unemployment rate declined somewhat since” the summer of 2015, “it remained elevated. Households spending continued to advance, and the housing sector showed further signs of improvement, but growth in business fixed investments slowed down. Inflation had been running somewhat below the Committee’s longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectations remained stable.” From this, to ensure price stability and generate a stronger economic recovery, the FED decided to maintain the discount rate.
Throughout the beginning of 2013, there was a debate over the discount rate and whether there is a need to change it. Such participants as the directors of the Federal Reserve Bank of Boston wanted to decrease the current rate to ½ percent, whereas the Bank of Kansas City was willing to increase that rate to 1 percent. Although having these debates, the discount rate stayed the same. Overall, during the first half of 2013, Federal Reserve Bank directors viewed actions in the economy as to be increasing at a moderate pace. The housing and auto sectors were strengthening their positions, employment was improving, though such departments as unemployment and manufacturing made directors left with opposite opinions.
By the end of 2013, almost all directors were delighted with the economy growth and there was no change in the discount rate in the end. Problems considering fiscal policy were gone, the labor environment was positive, the commercial and residential building department faced improvements. That all led most directors to vote for the discount rate to stay as it was.
Although the discount rate haD stagnated at 0.75% during 5 years, the FED decided to FINALLY increase it to 1 % on December 2015. Then it was set to 1.25% on December 2016. This WAS the second time in 10 years that the FED increaseD the discount rate, and the first time after the Donald Trump’s election. Moreover, it will rise gradually in the coming months to a level that is still unCERTAIN TO the financial world.
Because of the conditions on the current market, and inflation, the FED decided to increase the discount rate. Therefore, many improvements in the economy, MULTIPLIED consumer spending and a growth in the manufacturing industry have been noticed after THE AUGMENTATION OF this rate. In fact, the economy recovered, and the unemployment rate HAS BEEN decreasING during this current year. As a consequence, the GDP incremented in the USA. Consumers spend more money, and they are able to borrow despite the high interest rateS thanks to their greater income. These are the reasons why, the board of directors voted to INCREMENT the discount rate in November 2016.
as THE inflation is still rising, the Federal Open Market Committee forecast that the interest rate will reach 1.4% in 2017, and 2.1% in 2018. Thus, the Fed haS to establish the discount rate according to the economic situation IN the USA.