The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they received from their regional Federal Reserve Bank’s lending facility. Through a discount rate chosen, a central bank can keep an eye on the multiplicity of the money available in the market. In fact, a huge discount rate means that the FED, for example, wants the money supply to decrease since the commercial bank will be more careful when lending or will be less incentive to take out a loan from the central bank. In that case, this commercial bank will make less loans and thus, follow some economic activities such as the investments will be less; then, the money supply will decrease. This tool as it is used by the Federal Reserve to control the money supply, is a key in this case for preventing inflation. If the Federal Reserve wants in the contrary increase the money in order to lead to an inflation, the discount rate will be low.
An Overview of the Discount Rates set from 2007 to 2017
This graph below describes the discount rate chosen by the FED for 10 consecutive years. From 2007 to now, rate has tremendously decreased; as it can be seen, it goes from 5.2 to 0.75. It must be remarked that this graph has 3 periods. The first period is from the year 2007 to 2009; this period portrays a big decrease of the discount rate. Next, the second period lasts for 7 years (2009-2015) and the rate did not change; in fact, it remains unchanged (0.5) from 2009 to 2015. The last one which begins in 2016 until now is subject to a slight increase.
Analysis of the FED’s federal discount rates over the last 10 years
- First period (2007-2009):
The Fed had viewed the financial turbulence that had rocked financial markets over those last few weeks as primarily a liquidity crisis and not as an economic crisis. Since financial market conditions had deteriorated, and tighter credit conditions and increased uncertainty to have the potential to restrain economic growth going forward, the Federal Reserve Board approved a cut in the discount rate, the rate at which banks may borrow directly from the Federal Reserve, of 50 basis points to 5.75%. The Fed also announced that it was changing the standard terms of loans at the discount window to allow for borrowing up to 30 days
The reduction in the discount rate was the latest move by the Fed to provide liquidity to parts of money markets that need it.
- Second period (2009-2015)
After the financial crisis and Great recession, the discount rate decreased a lot. It was equivalent to 2% in 2008 and it was only 0,25% in 2009.
Between 2009 and 2015 there is a stability between 0 and 1 percent of the rate, it is called the « period of 0 rate » or also an « above-market rate ».The fed fund rate tends to fall.
In 2010, the maximum term on discount window loans has been reduced back to overnight.
This monetary policy adopted a floor system. It promotes the efficient functioning of the financial system by allowing banks to earn the market rate of interest on all of their reserve balances.
This monetary policy is due to 2 things: because the Fed began paying interest on reserves. And also it purchased assets such as Treasuries through, which led to an important increase in the stock of reserves.
- Third period (2015-2017)
Since the end of 2015, the discount rate of the FED has started to increase slowly. Indeed, by the beginning of February 2017, the rate is 0.75% compared to only 0.5% in 2016. Although this quarter percentage point of increasing seems weak, it shows the optimism of the FED and also that the American economy is going better.
This period represents the first raise of the discount rate of the decade. And in 2017, the FED anticipates 3 increases of its rate. Therefore, we can expect a sustainable rise for the following years.